How to beat The Little Book That Beats The Market: Redux (Part 3)

How to beat The Little Book That Beats The Market: Redux (Part 3)
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How to beat The Little Book That Beats The Market: Redux (Part 3)

In How to Beat The Little Book That Beats The Market: Redux (and Part 2) I showed how in Quantitative Value we tested Joel Greenblatt’s Magic Formula outlined in The Little Book That (Still) Beats the Market).

We created a generic, academic alternative to the Magic Formula that we call “Quality and Price,” that substituted for EBIT/TEV as its price measure the classic measure in finance literature – book value-to-market capitalization (BM):

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BM = Book Value / Market Price

Quality and Price substitutes for ROIC a quality measure called gross profitability to total assets (GPA). GPA is defined as follows:

GPA = (Revenue ? Cost of Goods Sold) / Total Assets

Like the Magic Formula, it seeks to identify the best combination of high quality and low price. The difference is that Quality and Price substitutes different measures for the quality and price factors. There are reasonable arguments for adopting the measures used in Quality and Price over those used in the Magic Formula, but it’s not an unambiguously more logical approach than the Magic Formula. Whether one combination of measures is better than any other ultimately depends here on their relative performance. So how does Quality and Price stack up against the Magic Formula?

Here are the results of our study comparing the Magic Formula and Quality and Price strategies for the period from 1964 to 2011. Figure 2.5 from the book shows the cumulative performance of the Magic Formula and the Quality and Price strategies for the period 1964 to 2011.

Magic Formula vs Quality and Price

Quality and Price handily outpaces the Magic Formula, turning $100 invested on January 1, 1964, into $93,135 by December 31, 2011, which represents an average yearly compound rate of return of 15.31 percent. The Magic Formula turned $100 invested on January 1, 1964, into $32,313 by December 31, 2011, which represents a CAGR of 12.79 percent. As we discuss in detail in the book, while much improved, Quality and Price is not a perfect strategy: the better returns are attended by higher volatility and worse drawdowns. Even so, on risk-adjusted basis, Quality and Price is the winner.

Figure 2.7 shows the performance of each decile ranked according to the Magic Formula and Quality and Price for the period 1964 to 2011. Both strategies do a respectable job separating the better performed stocks from the poor performers.

Qp MF Decile

This brief examination of the Magic Formula and its generic academic brother Quality and Price, shows that analyzing stocks along price and quality contours can produce market-beating results. This is not to say that our Quality and Price strategy is the best strategy. Far from it. Even in Quality and Price, the techniques used to identify price and quality are crude. More sophisticated measures exist.

At heart, we are value investors, and there are a multitude of metrics used by value investors to find low prices and high quality. We want to know whether there are other, more predictive price and quality metrics than those used by Magic Formula and Quality and Price.

In Quantitative Value, we conduct an examination into existing industry and academic research into a variety of fundamental value investing methods, and simple quantitative value investment strategies. We then independently backtest each method, and strategy, and combine the best into a new quantitative value investment model.

Order from Quantitative Value from Wiley Finance, Amazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.

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My name is Tobias Carlisle. I am the founder and managing member of Eyquem Investment Management LLC, and portfolio manager of Eyquem Fund LP. Eyquem Fund LP pursues a deep value, contrarian, Grahamite investment strategy based on the research featured in Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (hardcover, 288 pages, Wiley Finance, December 26, 2012), and discussed on Greenbackd. I have extensive experience in activist investment, company valuation, public company corporate governance, and mergers and acquisitions law. Prior to founding Eyquem, I was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions I have advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam, ranging in value from $50 million to $2.5 billion. I am a graduate of the University of Queensland in Australia with degrees in law and business (management). Contact me I can be contacted at greenbackd [at] gmail [dot] com. I welcome all feedback. Connect on LinkedIn, where we’re Friends.

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