Does The Magic Formula Also Work In Finland? by Tim du Toit, Quant Investing

Joel Greenblatt proved that his Magic Formula investment strategy, as described in his excellent book The Little Book that Still Beats the Market, works in the US markets.

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Magic formula works in the Benelux

And Pim Postma in his 2015 Bachelor thesis Magic Formula Investing in the Benelux proved that the Magic Formula also works in the Benelux (Belgium, Luxembourg and the Netherlands) stock markets where it was able to realise an average 7.70% annual market outperformance without taking additional risk during the 20 year period from 1995 till 2014.

You can read more in the article Does the Magic Formula also work in Belgium, Luxembourg and the Netherlands?

Does it work in Finland?

But does the Magic Formula also work when applied to companies listed in Finland?

Magic Formula Finland It does, and it was proved in 2013 by Topias Kukkasniemi in his 68 page master’s thesis The  Use  of  Systematic  Value  Strategies  in  Separating The Winners From The Losers: Evidence From The Finnish Markets  at the Lappeenranta University of Technology in Finland.

Topias tested the Magic Formula on the Finnish stock market over the 13 period from May 1997 to May 2010 and found that the strategy does outperform the market.

Counterintuitive discovery

But he also made a counterintuitive discovery that can increase your return from the Magic Formula which you will find interesting so keep reading.

Tested the Magic Formula and other strategies incl. ERP5

Topias did not only test the Magic Formula but also the ERP5 investment strategy (that performs even better than the Magic Formula) developed by Philip Vanstraceele and Luc Allaeys, two good friends of mine.

You can read more about the ERP5 investment strategy here: A better alternative to the Magic Formula?

In this article I am going to focus on his testing of the Magic Formula.

What he found

This is what Topias found in his thesis:

"This study examines the Magic Formula and ERP5 value strategies in the Finnish stock market.

Magic  Formula  ranks  stocks  based  on  EV/EBIT and ROA and ERP5 based on EV/EBIT, ROA, P/B and five-year trailing ROA. The purpose of the study is to examine whether the value strategies can be used to generate excess returns over the market index.

The data has been collected from the Datastream database for the sample period from May 1997 to May 2010 and consists of the companies listed on the main list of Helsinki Stock Exchange. 

This  study  confirms  the findings  of  previous  research  that  value  premium  exists  in  the  Finnish stock markets  and  that  systematic  value  strategies  can  be  used  to  form portfolios that outperform the market index with lower volatility."

Source: The  Use  of  Systematic  Value  Strategies  in  Separating The Winners From The Losers: Evidence From The Finnish Markets

In plain English

In plain English he found that the Magic Formula investment strategy would have given you higher return than the overall Finnish stock market with less risk (wild up and down movements) over the 13 year test period.

What and how he tested

Back test universe

Topias limited his testing companies listed on the main list of Finland’s Helsinki Stock Exchange.

The data used in the thesis was from the Thomson Reuters Datastream database. If data was missing it was added from annual reports or company websites.

The number of companies in the back test universe ranged from 61 to 120 depending on the year. If a company has more than one series of shares listed, only the more liquid series is included in the sample.

As  suggested  by Joel Greenblatt  utility  stocks  were  excluded,  as  well  as  financials because  their  financial  statements  have  a  slightly  different  structure  and the  ratios  are  not  comparable  to  companies  operating  in  other  sectors, such as manufacturing.

How returns were calculated

Return calculations included dividends for both individual companies and the benchmark index.

He did not include taxes or transaction cost in the return calculations.

Time period

The time period tested in the study was the 13 years from 2 May 1997 to 2 May 2010. This is about equal to one business cycle. This gives you the chance to see how the strategy performs in up and down markets.

This period included some large market  movements such  as  the  tech  bubble  and  the  2007 to 2009  financial  crisis.

Equal weight portfolios (same amount invested in each company) were formed on the first trading day of May each year.

The portfolios were formed in May to minimize the risk of look ahead bias, as it takes a couple of months for the companies to publish their annual reports after their December year end.

The portfolios were held for a year until the first trading of May of the following year.

Testing the Magic Formula in Finland

Topias tested the Magic Formula slightly differently. Instead of using Return on Invested capital (ROIC) he used Return on Assets (ROA).

He did this for two reasons:

  1. Because the previous research on the relationship between ROA and high future returns is extensive.
  2. ROA  figures  are  more  easily  accessible  by  small  investors  than  ROIC.

ROA was calculated as follows: Earnings Before Interest and Taxes (EBIT) / Total Assets.

Test portfolios, a great idea

To test the strategies really thoroughly Topias divided companies into  four  categories (from best – Top 25% to worse – Bottom 25%)  based  on  their Magic Formula rankings.

This resulted in the following portfolios:

Magic Formula Finland

As you can see the total number of companies in the investment universe each year varied between 61 and 120. This  resulted in the number  of  companies  in  the  formed  portfolios varying between  15  and  30.


Now we come to the most important part – how well did the Magic Formula do in Finland?

Magic Formula Finland

As you can see the Magic Formula could definitely have helped you outperform the market.

Surprising finding - than increases your returns

But the surprising finding of the study is that the best ranked Magic Formula companies (MF Top 25%), thin blue line in chart above, did not perform the best.

You would have gotten better returns if you invested in the companies just below the top 25% of Magic Formula companies (MF Upper Mid 25%) the red line in the chart above.

Why is this, you may be thinking?

Topias speculated as to why it could be saying:

"A possible explanation for this could be that the stocks ranked in the top quartile are cheap for a reason and have only recently taken a turn to the worse so that the accounting ratios still look attractive although the business environment has changed. For some reason, Magic Formula seems to put the biggest gainers in the second quarter."

Better returns if you do this

This is a very interesting insight and is not something we have tested directly.

We have however found that you can get even better returns if you combine the Magic Formula with companies that have good six month share price momentum (6 month Price Index).

This is because good share price

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