How “Magic” is Magic Formula Investing?

How “Magic” is Magic Formula Investing?

May 28, 2011 Research Insights, Value Investing Research
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(Last Updated On: January 13, 2017)

 

The underlying concept of magic formula investing is a genius marketing platform, but it is unclear how “magic” the formula actually is–examine ‘cheapness,’ examine ‘quality,’ combine the analysis and buy the best value (get the most bang for your buck). The magic formula identifies quality via EBIT / (NPPE +net working capital) and cheapness via EBIT / TEV. These two measures are certainly not ‘bad’; however, they are also not necessarily optimal.

We are always exploring alternatives to the magic formula found in academic finance research. In fact, we highlighted the ‘academic version’ of the magic formula in the following post:

http://blog.alphaarchitect.com/2011/02/the-other-side-of-value/

The “profit and value” strategy identifies cheapness via book-to-market, and identifies quality via gross-profits-to-total-assets.

Next, we backtested the magic formula and the profit and value system and compared them in a head-to-head battle. We tested a portfolio that is annually rebalanced on June 30th (only stocks >80% NYSE market cap breakpoint are included). The portfolio is rebalanced across 30 stocks on July 1st and held until June 30th.

First the Drawdowns:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Very similar, with a slight edge for profit and value.

Next, the overall performance:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Again, slight edge for profit and value, but very little overall difference.

And how about the year by year comparison?

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Honestly, looks like a pretty even match–amazingly similar!

Key Takeaway:

Focusing on quality and cheapness simultaneously helps investors beat the market

However…

THE MAGIC FORMULA AIN’T THAT MAGIC!

Additional study…

Here is a document with the summary results of the comparison between profit and value and the magic formula for broad market (as defined as market cap >20% breakpoint on the NYSE) and for large caps, exclusively (as defined as market cap >80% breakpoint on the NYSE):

Click to get the pdf file.

Key Takeaways:

  1. Profit and value is arguably better than the magic formula.
  2. Both strategies have significant risk in the form of large drawdowns.
  3. Long/short systems based on quality/cheapness factors are DANGEROUS!

Recommendation:

Explore the use of quality/cheapness factors for long-only investment systems, but be prepared for a very volatile ride.

If you are interested in trading either system, head to Empirical Finance Data. We do all the calculations, so you can try and make some money.

 


Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.


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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.


Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.