Greenblatt's Magic Touch Falls Short? Magic Formula Large And Mid Cap Q1 Update

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Includes: AET, AGX, AMCX, AOBC, ARA, CA, CSCO, DISCA, FPRX, GILD, HLF, HRB, HUM, ICON, IDCC, KORS, MMI, MSGN, PINC, RMR, SCMP, SNI, SSNI, SYNT, TARO, TGNA, TNH, UEPS, UTHR, VVV
by: Ryan Telford

Summary

Magic Formula investing of buying "good" companies at "cheap" prices has outperformed over time.

Whereas the large cap version of this strategy beat its benchmark in Q1, the large and mid-cap strategy struggled and reported a loss.

We look at the historical performance of the strategy to maintain a long term view.

(Credit: michaelkonik.com)

Joel Greenblatt developed a quantitative "buy and hold" value investing strategy to find stocks of quality companies selling at bargain basement prices. This strategy is of course the Magic Formula. The strategy scores stocks on two main criteria, quality (or a high return on capital) and price (a low EV/EBIT, a more refined version of the P/E ratio). For a detailed look at this strategy and historical performance please read my profile of this strategy here.

In a recent article we looked at performance of the Large Cap version of this strategy (largest 20% of stocks in the testing universe by market cap). The strategy beat the benchmark for the first quarter of 2017, managed to stay ahead of the benchmark for virtually the entire period.

The large and mid cap strategy screens from the largest 50% of stocks by market cap. In some strategies, the less large cap holdings that are included in the strategy the better, as smaller cap stocks have more of a tendency to be mispriced as they have less analyst coverage. Other strategies may be more aligned with larger cap stocks. In the Magic Formula strategy for example, the large cap strategy has had a slight edge over the large and mid cap strategy, or 16.6% vs. 15.7% respectively from 1999 to 2015 (source).

Let's see how the Large and Mid Cap strategy performed in Q1 of this year.

The Holdings

The table below summarizes the stocks passing the screen on January 1st of this year, their price performance over the quarter and some other helpful metrics.

Ticker

Name

01 Jan 2017

31 Mar 2017

Change (%)

Market Cap ($M)

Industry

FPRX

Five Prime Therapeutics Inc

51.07

36.73

-28.08

1,423

Biotechnology

RMR

RMR Group Inc (The)

39.32

49.1

24.89

635

Diversified Real Estate Activities

GILD

Gilead Sciences Inc

71.79

67.37

-6.15

94,668

Biotechnology

MMI

Marcus & Millichap Inc

27

24.45

-9.44

1,005

Real Estate Services

UTHR

United Therapeutics Corp

144.12

136.93

-4.99

6,119

Biotechnology

AGX

Argan Inc

71.95

65.6

-8.83

1,078

Construction & Engineering

TARO

Taro Pharmaceutical Industries Ltd

105.34

119.71

13.64

4,502

Pharmaceuticals

PINC

Premier Inc

30.41

31.85

4.74

1,459

Health Care Services

SYNT

Syntel Inc

19.89

16.81

-15.49

1,664

Data Processing & Outsourced Services

HUM

Humana Inc.

202.19

206.42

2.09

30,421

Managed Health Care

ICON

Iconix Brand Group Inc

9.58

7.45

-22.23

525

Apparel, Accessories & Luxury Goods

MSGN

MSG Networks Inc

21.8

23.4

7.34

1,614

Cable & Satellite

IDCC

InterDigital Inc

92.09

85.75

-6.88

3,132

Communications Equipment

VVV

Valvoline Inc

21.62

24.32

12.47

4,408

Commodity Chemicals

AMCX

AMC Networks Inc

52.81

58.45

10.68

3,702

Cable & Satellite

SCMP

Sucampo Pharmaceuticals Inc

13.7

11.1

-18.98

580

Pharmaceuticals

ARA

American Renal Associates Holdings Inc

21.3

16.85

-20.89

657

Health Care Services

HRB

Block (H&R) Inc

22.87

23.15

1.21

4,862

Specialized Consumer Services

AOBC

American Outdoor Brands Corporation

21.19

19.66

-7.22

1,186

Leisure Products

TGNA

TEGNA Inc

21.5

25.83

20.12

4,586

Broadcasting

TNH

Terra Nitrogen Co LP

101.84

96.24

-5.5

1,900

Fertilizers & Agricultural Chemicals

HLF

Herbalife Ltd

48.72

58.67

20.42

4,482

Personal Products

CA

CA Inc

31.8

31.76

-0.14

13,126

Systems Software

AET

Aetna Inc.

124.6

126.71

1.7

43,515

Managed Health Care

CSCO

Cisco Systems Inc

30.11

33.72

11.98

151,825

Communications Equipment

DISCA

Discovery Communications Inc

27.66

28.72

3.83

11,649

Broadcasting

SSNI

Silver Spring Networks Inc

13.47

11.42

-15.22

691

Application Software

SNI

Scripps Networks Interactive Inc

71.24

78.6

10.34

9,214

Broadcasting

UEPS

Net 1 Ueps Technologies Inc

11.58

12.25

5.79

603

Data Processing & Outsourced Services

KORS

Michael Kors Holdings Ltd

42.78

38.24

-10.61

7,059

Apparel, Accessories & Luxury Goods

(Source: Portfolio123.com data and Author Table)

Readers familiar with the large cap version of the strategy may see some of the same names in this listing.

Our Large Cap strategy was very concentrated with firms in pharma or healthcare; the Large and Mid Cap strategy above includes some of the latter, but is fairly well rounded in terms of industry distribution.

Overall Performance

The graph below plots the return of the Large and Mid Cap Magic Formula portfolio against the Russell 3000TR benchmark.

(Source: Portfolio123.com and Author Graph)

In the first few weeks of the year, both the Magic Formula and the benchmark appeared to be similarly correlated; it was around the 3 rd week in January when the Magic Formula started to diverge and began to lag the benchmark, followed by a steep decline in the 3 rd week in February that continued until the end of the quarter. The last week of the quarter teases a recovery.

Overall performance of the Large & Mid Cap Magic Formula strategy was -1.19% over the quarter, compared to the Russell 3000TR's 5.04%. As can be seen from the graph above, drawdown in the strategy was significantly more than the benchmark (7.53% and 2.39% respectively).

The Good & The Bad

The number of holdings that appreciated over the period was the same as those that lost value (15 in each group, 30 holdings total). Eight (8) of the holdings managed to appreciated 10% or more over the period, from a fairly diversified group of industries.

Of the 15 holdings that showed a loss over the period, three (3) were greater than 20%.

Why the Disparity with the Large Cap Strategy?

The first quarter of this year has been an interesting one, with the earlier portion benefiting from the Trump Bump. The latter half of the quarter had many key developments: the Fed announcing rate hikes, the "Trump Trade" running out of steam, and some pundits declaring a general market correction may explain the drop in performance in the latter half of the quarter.

But why did the Large Cap strategy of the Magic Formula perform markedly better over the period? Several possible reasons; perhaps in the volatility and uncertainty, investors felt safer in the large cap names, bidding up prices. Recall that the Large Cap portfolio was 50% pharma/healthcare, the performance of which on balance was relatively neutral.

Keep in mind that one quarter is a relatively short period of time for a strategy such as this. Over time the differences between the two market cap classes of the strategy should disappear.

I am invested in another quant value strategy that has been hit particularly hard in the last 4 weeks relative to the benchmark, whereas the same strategy in the US market is outperforming the benchmark. Short term conclusions can be difficult to arrive at, especially with sentiment generally playing a major role, while fundamentals typically matter more in the long run (think Graham's voting machine/weighing machine analogy).

Long Term

The graph below shows rolling 5 year CAGR difference between the strategy and the benchmark since 1999.

(Source: Portfolio123.com data and Author Graph)

I showed a similar graph when looking at the Large Cap quarterly update. While the strategy has produced a positive outperformance, the curve above does show a general trend downwards. 2010 through 2012 showed a negative 5 year CAGR, offset by superior returns in 2013 and 2014, returning to negative territory until the end of 2015.

As we noted, one quarter is a short time period to assess the overall performance of any long term strategy, however many investing strategies are cyclical, having peaks of outperformance and droughts of underperformance. Knowing where a strategy has been can be helpful for the future.

Until next time, happy investing.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a user of Portfolio123.com, and have included affiliate links in the article above. Should readers purchase a membership from P123 via my link, I will receive a nominal commission, with no extra charge to the reader. Thank you in advance.