The NEW Magic Formula's Best and Worst Stocks

Casting a Spell on Your Portfolio

In Joel Greenblatt’s book "The Little Book That Beats the Market," he developed a quantitative investing strategy known as the Magic Formula. The Magic Formula seeks high quality stocks at low prices by looking primarily at two metrics: the earnings yield (EY), defined as operating income/enterprise value, and return on capital (ROC). These two metrics are simple, logical, and presumably effective. Greenblatt is more than happy to tout the formula’s back-tested results. In fact, he offers readers the opportunity to freely try the strategy on their own by visiting MagicFormulaInvesting.com, buying the top 30 – 50 stocks that the screener provides (you can change market cap minimums if you like), and rebalancing once per year.

Now, Robert Novy-Marx, assistant professor of Finance at the Simon Graduate School of Business at the University of Rochester, New York, and a faculty research fellow of the National Bureau of Economic Research, has created his own dual-metric “magic” formula that claims superior, back tested results. How does it work? Mr. Novy-Marx explains:

I employ gross profits-to-assets and book-to-market as the quality and price signals here because these yield trading strategies that are far more profitable than strategies based on ROC and EY.

And unlike Mr. Greenblatt’s strategy, whose higher returns are frequently attributed to buying small-cap stocks, Novy-Marx’s back tested results came using only large-caps.

The signal in gross profitability is extremely persistent, and works well in the large cap universe. Profitability strategies thus have low turnover, and can be implemented using liquid stocks with large capacities.

Novy-Marx says that value investors who base their decisions strictly on price signals could benefit from the diversification added by incorporating quality stocks, and those who base their decisions on quality with little regard to price would benefit from incorporating stocks based on price signals. The back tested results look to confirm this. The joint price-value strategies performed better and with less risk than either alone in most periods.

And unlike Mr. Greenblatt’s strategy, whose higher returns are frequently attributed to buying small-cap stocks, Novy-Marx’s back tested results came using only large-caps.

The signal in gross profitability is extremely persistent, and works well in the large cap universe. Profitability strategies thus have low turnover, and can be implemented using liquid stocks with large capacities.

Novy-Marx says that value investors who base their decisions strictly on price signals could benefit from the diversification added by incorporating quality stocks, and those who base their decisions on quality with little regard to price would benefit from incorporating stocks based on price signals. The back-tested results look to confirm this. The joint price-value strategies performed better and with less risk than either alone in most periods.

Getting Started: Value Investing With Novy-Marx

In order to replicate this investment process an investor would have to:

1. Take the top 500 largest non-financial and non-utility stocks

2. Rank them according to price using Price-to-Book or Book-to-Market

3. Rank them according to quality using Gross Profits-to-Total Assets

4. Sum the two rankings to determine each stock's combined ranking

5. Purchase the top 150 stocks with the lowest combined ranking

6. And short the bottom 150 stocks with the highest combined ranking, if using a long/short strategy.

On March 6, 2013, I followed this ranking process and summarized the top and bottom 30 stocks below:

Top 30 Stocks




Bottom 30 Stocks



Note: I began with the S&P 500 and eliminated financial and utility stocks without replacing them. Therefore my selection universe was approximately 400 companies, less than the 500 used in the back test.

Conclusion with a Warning

It will be interesting to see how these stocks perform over the next year.

Keep in mind that this methodology of ranking stocks against one another is all relative value. If the entire universe of stocks is overpriced, as is the case in a bubble, then you will only be choosing the best of the worst. That should still allow you to perform better than the overall market, but it will not help those seeking absolute return.

Likewise, if everyone began investing using this formula then efficient pricing would eliminate this strategy’s excess returns. Regarding the Magic Formula, Greenblatt confidently stated that scenario is unlikely to happen because most investors would abandon the strategy during the years of the formula’s under-performance, and he is probably right. Still, I would advise interested investors to use the formula as a way to find interesting stocks for further research. In other words, don’t put blind faith into it.

To read Mr. Novy-Marx’s full study with more details on the various investment strategies that can be utilized with his formula, click here. I also want to thank the excellent investing blog Greenbackd for bringing this study to my attention.

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James DeMasi, CFA is CIO of Seraphin Group, a registered investment advisor. For more information please please visit Seraphingroup.com.