(excerpted from a paper written by Alpha Vee principals)
What can we do about Mr. Market’s split personality?
Some sectors are stable and calm while others are jumpy and nervous. The reasons may be fundamental in nature, or they may be due to singular events. The recent Facebook debacle is a prime example. One company’s tribulations affected the whole sector. Even advocates of fundamental analysis must admit that the governing fundamentals for each sector can vary considerably.
The starting point for our solution is Joel Greenblatt’s well-known Magic Formula — arguably one of the main precursors of the smart beta exchange-traded fund (ETF) industry.
The Magic Formula: A Short Review and Analysis
Greenblatt published The Little Book That Beats the Market in 2005. In those days, the nascent smart-beta industry had only $50 billion in assets under management (AUM), far from the $1 trillion it accounts for today.
Greenblatt’s Magic Formula is based on ranking a large universe of about 1,000 companies according to two factors: return on capital (ROC) and earnings yield (EY). The top 20 to 30 companies are kept in a portfolio for one year and then the deck is reshuffled.
That’s simple enough for most investors to understand and execute, and according to Greenblatt, the historical simulation looked great too.
To be sure, there are more details in the Magic Formula method. The key point though is the disciplined quantitative approach: Buy companies based on reported data, not headlines or expectations, and keep them for a defined
period.
This, in essence, is the logic behind smart-beta ETFs, which work according to a rulebook, with very little human judgment.
The Magic Formula ranks all companies the same way, no matter which sector they belong to, though Financial and Utilities are explicitly excluded.
We ran some historical simulations with a Magic Formula-like strategy, excluding the Financial and Utilities sectors, and graded a universe of US companies, with market caps of $1 billion and above, based on ROC and PE only. We picked the top 30 stocks and weighted them equally and rebalanced quarterly.
Though the principles are similar, there are some differences between the way we simulated the strategy and the way it is done in Greenblatt’s book. So our analysis is not analogous to pure Magic Formula results.
Our results from 2008 to 2017 outperformed the S&P 500. However . . .
Want more? You'll have to get in touch with Alpha Vee for the rest of the story.
