A New and Improved Magic Formula?


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Is This the New Magic Formula?

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, 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. Novy-Marx explains:
"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 have to:

  • Take the top 500 largest non-financial and non-utility stocks
  • Rank them according to price using Price-to-Book (Book-to-Market)
  • Rank them according to quality using Gross Profits-to-Assets
  • Sum the two rankings to determine each stock's combined ranking
  • 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.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing
More Headlines for: ABX , APPL , BIDU , GG , ROC

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