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The NEW Magic Formula's Best and Worst Stocks

March 11, 2013

3540089-illustration-of-a-magic-wand--wh



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.
mf20-results.png

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.

mf20-drawdowns.png

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

Getting_Started.jpg



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



Ticker


Company


Quality Rank


Price Rank


Combined Ranking


GME


GameStop Corp.


43


45


88


APOL


Apollo Group Inc.


7


88


95


SPLS


Staples, Inc.


62


40


102


BBY


Best Buy Co. Inc.


26


84


110


SWY


Safeway Inc.


21


99


120


JCP


J. C. Penney Company, Inc.


103


18


121


ANF


Abercrombie & Fitch Co.


9


134


143


AZO


AutoZone Inc.


28


119


147


KSS


Kohl's Corp.


72


80


152


WAG


Walgreen Co.


49


108


157


PSX


Phillips 66


65


102


167


MUR


Murphy Oil Corporation


148


37


185


DGX


Quest Diagnostics Inc.


70


120


190


IPG


The Interpublic Group of Companies, Inc.


68


129


197


WPO


The Washington Post Company


171


27


198


WDC


Western Digital Corp.


163


47


210


HAR


Harman International Industries Inc.


126


86


212


TER


Teradyne Inc.


128


85


213


NVDA


NVIDIA Corporation


154


65


219


FRX


Forest Laboratories Inc.


146


76


222


TSO


Tesoro Corporation


132


91


223


INTC


Intel Corporation


112


113


225


M


Macy's, Inc.


60


167


227


APA


Apache Corp.


214


13


227


ABT


Abbott Laboratories


122


106


228


BIG


Big Lots Inc.


6


223


229


CVS


CVS Caremark Corporation


159


71


230


WM


Waste Management, Inc.


55


177


232


MRO


Marathon Oil Corporation


201


35


236


CVX


Chevron Corporation


169


68


237



Bottom 30 Stocks



Ticker


Company


Quality Rank


Price Rank


Combined Ranking


KMI


Kinder Morgan, Inc.


380


189


569


DLPH


Delphi Automotive PLC


233


337


570


HRB


H&R Block, Inc.


207


364


571


FLR


Fluor Corporation


374


198


572


UPS


United Parcel Service, Inc.


192


385


577


SRCL


Stericycle, Inc.


253


326


579


PAYX


Paychex, Inc.


223


361


584


KRFT


Kraft Foods Group, Inc.


219


367


586


F


Ford Motor Co.


381


212


593


WU


Western Union Co.


232


374


606


ABC


AmerisourceBergen Corporation


278


328


606


ICE


IntercontinentalExchange, Inc.


398


213


611


MO


Altria Group Inc.


212


400


612


COL


Rockwell Collins Inc.


231


394


625


RRC


Range Resources Corporation


310


322


632


BLL


Ball Corporation


291


343


634


DE


Deere & Company


336


302


638


OI


Owens-Illinois, Inc.


333


306


639


NFLX


Netflix, Inc.


246


395


641


GT


Goodyear Tire & Rubber Co.


271


372


643


COG


Cabot Oil & Gas Corporation


308


344


652


FTI


FMC Technologies, Inc.


305


352


657


WY


Weyerhaeuser Co.


379


278


657


WYNN


Wynn Resorts Ltd.


256


403


659


ADP


Automatic Data Processing, Inc.


360


304


664


AMT


American Tower Corporation


325


373


698


WMB


Williams Companies, Inc.


356


354


710


LMT


Lockheed Martin Corporation


327


406


733


CCI


Crown Castle International Corp.


375


358


733


PCL


Plum Creek Timber Co. Inc.


383


351


734


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.

-----------------------------

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

About the author:

jdemasi
I began investing when I was thirteen years old. Although I studied finance throughout college and graduate school, I feel that nothing beats real, practical experience. When it comes down to it, there's nothing else I'd rather be doing than managing investment portfolios for myself and others.

Visit jdemasi's Website


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