Strategy Test – Joel Greenblatt’s “Magic Formula”

Strategy Test – Joel Greenblatt’s “Magic Formula” by Bargain Value

Today, we are going to test the strategy of the next investing guru – Joel Greenblatt, who published it in his book called: "The little book, that beat the market". In this book you can find the following table with the results:

As we see, over the last 17 years, Magic Formula has earned on average 30.8% annualy. It is an enormous return. In the same time, the S&P 500 has produced only 12.4% annualy. A huge difference of 18.4 percentage points. However, Greenblatt could have some luck, because he was testing his formula during better than average years.

What are these “magic” criteria?

• the company’s capitalization must be bigger, than 50 ml $ ( approx. £ 36 ml)
• we exclude the companies from the finance sector (banks, insurers) and utilities providers (gas, electricity, water)
• we include only native companies. We don’t take these, which are only listed on LSE
• The main criterion – we create a rank from the remaining companies according to 2 indicators:
  • EV/EBIT – the company’s value to operating profit. It points out the relatively, cheap stocks
  • ROIC – the operating profit divided by the fixed and working capital. It is a profitability criterion, which points out the high, value companies (they can produce high return in comparison to the managed capital).

Later, in this article we will test our own variation of "Magic Formula". We haven’t applied the 2 bold criteria and added 2 standard ones (the minimal price higher than 20 p. and the weekly volume higher than 8000k p.). The 2 criteria, which have been omitted by us, are too complicated to include in our database.

In the Greenblatt’s book you can find a couple of additional information. The best results can be achieved, when you invest in 20-30 companies. You shouldn’t buy them at once, but accumulated them for 2-3 months. There is an information about the annual, folio revision. With reference to these criteria, we will check a three different amount of stocks and use the constant revision. Although, before we will present our analysis, we would like to examine the findings of other people, who has written about this subject before.

1. The Old School Value has obtained a 13.74% annual return, which beats the market return by 12.87 percentage points, during the same period of time,
2. Here, we have a repetition of Greenblatt’s test since 1965. MF has earned 12.46% annualy. In the same time, the american market has grown only by 9.44% (the difference of +3 pp.),
3. In this test, the MF beats the S&P 500 by 3 pp.. However, they have tested the strategy on the same years as in the Greenblatt’s book and have achieved “only” 13.8% annual return,
4. The QuantInvesting has proved, that the strategy works in the Benelux countries and beats the market by 7.7 percentege points per year. Their other test suggests, that the "Magic Formula" works even on the small, Finish market. Moreover, they have established, that the companies ranked from 26% to 50%, produce better results, than the first quartile,
5. On the other hand, our friends from Stockopedia are very certain, that the formula doesn’t work on the UK market and has underperformed FTSE 100 during recent years.

We have 4 votes for “Yes” and one vote for “No”. However, each one of this tests support the fact, that it is impossible to obtain such high return as in the Greenblatt’s book. The best result has beaten the S&P 500 “only” by 12.87 pp. Due to this fact, we can expect, that our test won’t beat the market by more, than 3-10 pp.. Let’s check, if it’s true. We will start with the test, which has included 20 stocks, traded constantly (when a new stock appears in the best 20 stocks ranked by the MF, we buy it immediately). On the chart below, you can see the result:

As we can see, this strategy has beaten the NW index by 3.62 pp.. However, as we’ve said earlier, the NW index is an artificial instrument and if we compare the result of 12.96% with an average, ETF’s (FTSE All Share) annual return of 7%, this difference will be much higher (+6 pp.). The maximal drawdown is 14 pp. smaller, which is a very good result. Although, there is one big drawback of this strategy. The green line (difference between folio and NW index) shows, that most of its advantage has been created during the bear market of 2007-2008 and the boom in 2009. From 2010 to 2013 the strategy wasn’t better, than NW index and during the last 2 years, it was worse. Due to this fact, we cannot count on the stability of this results. The folio was 100% full during the whole test. Normally, it could make us vulnerable to the bear markets, but as we’ve established, MF has behaved a lot better than the market, during the last big slump.

Despite this fact, the MF’s average annual return is greater, than the market’s. It means, that our variation of this strategy works on the LSE. However, it is not an end of our test. Let’s check, what will happen, if we change the number of stocks in the folio. The table below, presents the return of each variant:

As we can see, the 20 stocks in the folio is not a best configuration. It is better to have 5 companies in your pocket, if you are using the "Magic Formula". What about the other features? The chart below presents the key statistics for the variant with 5 stocks:

The key statistics (maximal drawdown, % weeks of profit etc.) are similar. Only the annual profit is about 3 pp. higher in comparison to the folio of 20 stocks. However, such low number of companies makes our folio not well diversified.

What is more important, it argues with the QuantInvesting findings on the Finnish market, that it is better to exclude the first 25% companies according to MF ranking, because they can be cheap due to the fact, that the market has already taken into account the future problems. It is an interesting theory and we’ve tested it. We have used the “26-50%” criterium and later, the F-score higher than 6. You can check the results in the tabel below:

As you can see, these two methods don’t improve the returns. However, they confirm, that folio consisted with 5 stocks produces better annual profit. What’s more, the “26-50%” rule can give us a much lower maximal drawdown. The best folio has got this value on the level of only -15.38%. It implicate, that this additional criterium can lower the risk. On the other hand, it shorts the avg. transaction day almost to one month, which will jack up the transaction costs and lower the profits.

When the F-score has been an additional criterium, the maximal drawdown has been much higher, but on the other hand, the annual return was slightly better in comparison to “26-50%” rule. However, none of this two methods have improved the main feature – annual return.

Now, we know a lot about Greenblatt’s formula performance on the UK stock market. Let’s check, which stocks are currently ranked the highest:

Today, 338 stocks meet the criteria. Many in top 20 are connected with finance sector (CBG, CLIG, RAT etc.). If we exclude them, this combination will look like this:

A lot of big and well-know companies like for example GSK.

Conclusions:

• The variation closest to the orignal, beats the market by 3.62 percentage points annually,
• Reducing the number of stocks, can improve the returns,
• Choosing the stocks from the second quartile of MF rank, can lower the risk and maximal slumps,
• The Magic Formula worked very well from 2007-2009. The last 2 years, question its advantage over the market.