Time to move on from magic formula investing?

Joel Greenblatt’s simple stock-picking formula delivered great results in the past but may no longer be useful for today’s investing world. Phil takes a look at why this once popular stock screen now fails to consistently outperform the market.

A brief overview of the magic formula

The magic formula is the topic of Joel Greenblatt’s excellent The Little Book that beats the Market which was first published in 2005. The book remains a very easy read and is a great primer on identifying good businesses and valuation for new and experienced investors alike.

The beauty of the magic formula is its simplicity. It is about buying good companies at cheap valuations and this logic is still a very sound one.

Greenblatt uses only two financial ratios to underpin his strategy.

Good businesses are highlighted by their return on operating capital employed (ROOCE) or operating assets. The higher the return, the better the business is likely to be.

ROOCE is calculated by dividing a company’s trading profits or earnings before interest and tax (EBIT) by the assets used to generate those profits.

You can calculate a company’s operating capital employed by taking its capital employed and subtracting the value of goodwill on its balance sheet. SharePad does this for you so you don’t have to.

ROOCE = EBIT/Capital employed ex goodwill.

A company’s valuation is measured by its earnings yield which Greenblatt defines as EBIT divided by enterprise value(EV) or the market value of its assets. This measure can also be referred to as an EBIT yield if you prefer.

There is some debate on how to calculate EV properly but a common definition is the company’s market capitalisation plus net borrowings plus preferred equity plus equity minority interest. Pension fund deficits are essentially a form of debt/borrowings and can also be added.

Earnings yield = EBIT/Enterprise Value.

With three variables – EBIT, Capital Employed and Enterprise value – you have all you need to create the magic formula for picking shares.

To do so, you need to go through the following steps:

1. Select a market you want to invest in such as the FTSE All Share.
2. Exclude investment trusts, real estate investment trusts and financial companies from the list of shares. This is because they have a different financial make-up which is not suited to the formula.
3. Calculate the ROOCE and earnings yield for each company.
4. Rank the companies for both. The highest ROCE and EBIT yield will get a ranking of 1.
5. Add the rankings together to get a combined ranking.
6. Rank the companies again starting with the company with the lowest combined ranking.
7. Pick a portfolio of 20-30 shares with the lowest combined rankings.
8. Invest the same amount of money in each share.
9. Hold for one year and then complete the exercise again.

The performance of the magic formula

In order to write and sell a book on the magic formula, Greenblatt had to show that it actually worked. He showed his readers very strong evidence that it did.

Between 1988 and 2004, the magic formula delivered a compound average annual return of 30.8 per cent against 12.4 per cent for the S&P 500 index.

Since then it has been more of a rocky ride. It fared about the same as the S&P 500 during the down markets of the 2007-10 financial crisis period and has lagged the returns of it for most of the last decade.

There are some studies out there that have shown some outperformance of the magic formula but the gap has been nowhere near as big as the evidence presented in Greenblatt’s original book. On the web and on places such as YouTube, there are some very mixed reviews of the strategy from individual investors.

In the days when I was working for ShareScope full time, I wrote a few articles on applying the magic formula to the UK market with mixed results. You can check out the results here and here.

Back then I was quite enthusiastic about the magic formula but I have changed my mind since. I’ll explain why shortly.

UK magic formula investing underperforms over the last year

One of the most useful tools in SharePad is the ability to go back and calculate financial ratios on past dates.

I have done this with ROOCE and EBIT yield for one year ago to see what a UK magic formula portfolio from the FTSE All Share index would have looked like. The data has been exported into a spreadsheet and ranked.

The portfolio excludes financial companies, investment trusts and real estate investment trusts (REITs).

An evenly weighted twenty-stock portfolio would have looked like the one below.

Bear in mind, as SharePad currency does not contain data from companies that used to be listed and so there is a possibility that this portfolio contains some survivorship bias if a company that should have been included is no longer listed.

UK Magic Formula Portfolio from October 2022

TIDM	Name	1y ago ROCE (ex goodwill)	1y ago EBIT yield	ROCE Rank	EBIT yield rank	Combined Rank	% Total Return 1y
FXPO	Ferrexpo PLC	59.2	47.1	12	2	14	-35.8
SNWS	Smiths News PLC	62.8	22.6	8	7	15	37.6
DLAR	De La Rue PLC	39.0	30.1	21	4	25	-32.2
RIO	Rio Tinto PLC	36.4	27.5	25	5	30	13.6
AAL	Anglo American PLC	33.1	27.2	31	6	37	-12.2
IMB	Imperial Brands PLC	44.6	15.2	19	24	43	-6.6
SYNT	Synthomer PLC	31.8	18.7	32	14	46	-70.6
AAF	Airtel Africa PLC	35.1	15.2	30	24	54	-5.1
AEP	Anglo-Eastern Plantations PLC	25.6	47.0	56	3	59	-2.8
PAY	PayPoint PLC	60.9	11.1	9	53	62	-7.1
MGNS	Morgan Sindall PLC	30.2	14.8	36	29	65	38.4
DNLM	Dunelm Group PLC	39.9	11.2	20	51	71	38.1
PDL	Petra Diamonds Ltd	20.8	61.2	71	1	72	-55.3
LSL	LSL Property Services PLC	56.5	10.2	14	60	74	12.2
CAPD	Capital Ltd	21.9	19.8	69	11	80	0.9
ITV	ITV PLC	36.3	10.9	26	55	81	8.2
ANTO	Antofagasta PLC	22.5	15.5	63	22	85	31.2
DOCS	Dr. Martens PLC	60.1	8.9	10	81	91	-45.2
NXR	Norcros PLC	20.8	16.0	71	21	92	-15.8
HAS	Hays PLC	25.8	12.6	55	39	94	-7.7
	Portfolio						-5.8
	FTSE All Share						13.3

Source: SharePad

This portfolio has not performed well. 12 of the 20 shares lost money – some of them large amounts – with the portfolio delivering negative total returns of 5.8 per cent. This represented a significant underperformance of the FTSE All Share index which returned 13.3 per cent.

Buying cheap shares fared better but still lost money

Just buying the cheapest shares ranked by their EBIT yield also produced disappointing results.

UK Cheap shares based on October 2022 EBIT Yield

TIDM	Name	1y ago ROCE (ex goodwill)	1y ago EBIT yield	ROCE Rank	EBIT yield rank	Combined Rank	% Total Return 1y
PDL	Petra Diamonds Ltd	20.8	61.2	71.0	1	72	-55.3
FXPO	Ferrexpo PLC	59.2	47.1	12.0	2	14	-35.8
AEP	Anglo-Eastern Plantations PLC	25.6	47.0	56.0	3	59	-2.8
DLAR	De La Rue PLC	39.0	30.1	21.0	4	25	-32.2
RIO	Rio Tinto PLC	36.4	27.5	25.0	5	30	13.6
AAL	Anglo American PLC	33.1	27.2	31.0	6	37	-12.2
SNWS	Smiths News PLC	62.8	22.6	8.0	7	15	37.6
KMR	Kenmare Resources PLC	13.4	21.8	141.0	8	149	10.6
HWG	Harworth Group PLC	19.7	20.4	88.0	9	97	-2.9
DEC	Diversified Energy Company PLC	18.4	20.3	98.0	10	108	-32.2
CAPD	Capital Ltd	21.9	19.8	69.0	11	80	0.9
ENQ	EnQuest PLC	12.9	19.7	146.0	12	158	-47.1
MEGP	Me Group International PLC	17.7	18.8	103.0	13	116	70.7
SYNT	Synthomer PLC	31.8	18.7	32.0	14	46	-70.6
BDEV	Barratt Developments PLC	12.3	18.7	154.0	14	168	26.0
HOC	Hochschild Mining PLC	13.0	18.2	145.0	16	161	35.4
PDG	Pendragon PLC	18.6	18.0	96.0	17	113	26.5
IDS	International Distributions Services PLC	10.2	18.0	170.0	17	187	27.8
RDW	Redrow PLC	11.9	17.5	159.0	19	178	25.9
CEY	Centamin PLC	14.2	16.6	135.0	20	155	4.0
	Portfolio						-0.6
	FTSE All Share						13.3

Source: SharePad

This portfolio had fewer losing shares – nine – but still lost money and significantly underperformed the FTSE All-Share

Focusing on quality only delivers much better results but still underperforms

Selecting the shares with the highest ROOCE, and ignoring valuation, delivered much better results. 7 shares lost money with the portfolio only slightly underperforming the FTSE All Share index.

UK Companies with the Highest ROOCE October 2022

TIDM	Name	1y ago ROCE (ex goodwill)	1y ago EBIT yield	ROCE Rank	EBIT yield rank	Combined Rank	% Total Return 1y
RMV	Rightmove PLC	240.1	3.4	1	194	195	25.0
AUTO	Auto Trader Group PLC	187.7	5.1	2	154	156	22.3
888	888 Holdings PLC	86.1	7.9	3	99	102	-5.6
SGE	Sage Group (The) PLC	72.6	3.9	4	183	187	48.3
SCT	Softcat PLC	69.4	3.2	5	199	204	32.0
MOON	Moonpig Group PLC	64.1	8.1	6	96	102	22.0
MONY	Moneysupermarket.com Group PLC	63	6	7	136	143	37.6
SNWS	Smiths News PLC	62.8	22.6	8	7	15	37.6
PAY	PayPoint PLC	60.9	11.1	9	53	62	-7.1
DOCS	Dr. Martens PLC	60.1	8.9	10	81	91	-45.2
GAW	Games Workshop Group PLC	59.5	6.6	11	129	140	64.6
FXPO	Ferrexpo PLC	59.2	47.1	12	2	14	-35.8
REL	RELX PLC	58.9	3.6	13	186	199	34.4
LSL	LSL Property Services PLC	56.5	10.2	14	60	74	12.2
ALFA	Alfa Financial Software Holdings PLC	53.7	4.4	15	172	187	7.8
EXPN	Experian PLC	52.2	4.1	16	179	195	4.2
FDM	FDM Group Holdings PLC	51.9	3.1	17	201	218	-26.7
KNOS	Kainos Group Ltd	50.9	3	18	207	225	-9.5
IMB	Imperial Brands PLC	44.6	15.2	19	24	43	-6.6
DNLM	Dunelm Group PLC	39.9	11.2	20	51	71	38.1
	Portfolio						12.5
	FTSE All Share Index						13.3

Source: SharePad

What’s wrong with the magic formula?

Quality and value are important considerations with any stock investment. However, giving them equal importance as the magic formula does, may not be the right thing to do.

It used to serve as conventional wisdom in investing circles that the price you paid for shares was all important. It still is important, but maybe the value factor has been overplayed and is not as relevant in today’s markets as it was in the past.

With a 50 per cent weighting to value, the magic formula has been very similar to a value investing screen in an era when value investing has massively underperformed.

It is also the case that quality and value are often highly correlated with each other. High-quality businesses often attract high valuations and vice versa. Trying to buy a high-quality company for a low price is often hard to do, except perhaps in distressed market conditions.

Low valuations such as high EBIT yield are often a sign of a poor-quality business.

Trying to get a decent trade-off between quality and value – as the magic formula tries to do – looks increasingly difficult. You may end up with modest quality businesses at modest or cheap valuations which don’t perform.

Perhaps above all else, the magic formula ignores the role of future growth which is arguably the most important driver of long-term stock market returns.

Also, blindly buying a portfolio of 20-30 shares is no guarantee of success in any investment strategy.

The issue with the magic formula is it can put the investor into many shares in the same sector with the same quality and value characteristics. This concentration can do well if the shares perform well but if they don’t, the results can be disastrous.

What should the investor do instead?

First of all, they should not ignore quality and valuation. Valuation discipline is a key investing skill but you can become too obsessed and mean with it. Paying up for quality and growth tends to yield better investment returns in the long run than buying shares because they are cheap.

Growth is a key consideration. Without growth, investors are unlikely to experience the benefits of long-term value compounding that investing in shares can give.

Some quantitative investors or “quants” have adapted the magic formula to include growth and momentum (buying shares that have already performed well) factors and this is definitely worth exploring.

However, the key message should be that investing by numbers or formulas alone can be a risky strategy. Screens are best used as a basis for finding ideas for further research.

To be a good investor you need some understanding of numbers and financial statements, but there is no substitute for knowing what you own a slice of and the business behind the shares you might invest in.

~

Phil Oakley

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