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The NEW Magic Formula's Best and Worst Stocks

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.

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.

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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 Nasdaq, Inc.


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

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