Is This the New Magic Formula?
'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
). These two metrics are simple, logical, and presumably
effective. Greenblatt is more than happy to tout the formula's
back tested results, so much so that 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 highly liquid 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, like P/E or P/B, can benefit from the
diversification added by incorporating quality stocks, and those
who base their decisions on quality with little regard to price
can 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
strategy alone in most periods.
Getting Started: Value Investing with Novy-Marx
In order to replicate this investment process, an investor would
- Take the top 500 largest non-financial and non-utility
- Rank them according to price using Price-to-Book
- Rank them according to quality using Gross
- Sum the two rankings to determine each stock's combined
- Purchase the top 150 stocks with lowest combined ranking
- And short the bottom 150 with the highest combined ranking,
if using a long/short strategy.
I followed this ranking process and summarized the top and bottom
30 stocks on March 6, 2013 below.
Top 30 Stocks
|click here. I also want to thank the excellent
investing blog Greenbackd for bringing this study to my
attention. If you're unfamiliar with the blog then please
give it a look.
Disclosure: At the time of this writing Seraphin
Group is long ABT, INTC, PSX, and WAG.
About GuruFocus: GuruFocus.com tracks the stocks picks and
portfolio holdings of the world's best investors. This value
investing site offers stock screeners and valuation tools. And
publishes daily articles tracking the latest moves of the world's
best investors. GuruFocus also provides promising stock ideas in
3 monthly newsletters sent to