The NEW Magic Formula's Best and Worst Stocks

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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.


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.

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




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.

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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 The NASDAQ OMX Group, Inc.



This article appears in: Investing

Referenced Stocks: AMAT , GPS , PHMD , ROC , SBUX

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