How “Magic” is Magic Formula Investing?
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:
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:
Very similar, with a slight edge for profit and value.
Next, the overall performance:
Again, slight edge for profit and value, but very little overall difference.
And how about the year by year comparison?
Honestly, looks like a pretty even match–amazingly similar!
Focusing on quality and cheapness simultaneously helps investors beat the market
THE MAGIC FORMULA AIN’T THAT MAGIC!
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):
- Profit and value is arguably better than the magic formula
- Both strategies have significant risk in the form of large drawdowns.
- Long/short systems based on quality/cheapness factors are DANGEROUS!
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.
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.***
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