Which magic formula is the most popular

Olivier Dambrine 01 Aug 2014

(Intro from the June 2014 edition of the systematic value investor newsletter)

Over the past 5 years we gathered quite a few screens and ratios. We started off with Joel Greenblatt’s Magic Formula, based on his bestseller ‘The little book that beats the market’. Greenblatt explained in very simple words that you should buy companies with above-average return on capital at below- average prices. We were the first to test this formula on European data and make the formula available globally.

Greenblatt wasn’t the only one with a working formula. We discovered a paper written by Joseph Piotroski in which he explained another very simple formula with incredible results. Piotroski found that if you invest in low price-to-book companies, but filter out the ones with poor prospects using his own F-Score, you will beat the market with a considerable margin. James O’Shaughnessy on the other hand liked to search for value stocks but he combined this with a momentum component. His tiny titans strategy looked for low price-to-sales micro caps of which the share price increased significantly.

We used all these valuable insights to test some alternative strategies. We designed the ERP5 factor, combining Greenblatt’s ranking with price-to-book and ROIC of the last 5 years. This was based on wisdom shared by Graham & Dodd, who advocated the use of 5 to 10 year smoothed earnings to cover full economic business cycles and dampen the effect of expansions and recessions. Our tests also showed that if you combine the Greenblatt Magic Formula with F-Score, returns increase while reducing risk. In our last paper, the tests showed that the best strategies are multi-factor and have either a momentum factor or price-to- book as primary factor. The strategy with the highest return was to take the top 20% of stocks with the highest 6 month price index and then order this by price-to-book. We redesigned our screener from the ground up so everyone could put these strategies into practice.

Last year we added another screen, called Trended Value, described by O’Shaughnessy in the 4th edition of his bestselling quant book ‘What works on Wall Street’. According to his tests, this strategy showed an annual return of 21% annually during the test period. (1964-2009). Instead of focussing on particular ratios, he combined 6 value ratios into 1 and ranked stocks based on this value composite.

He took the top 10% and sorted the results by 6 month price index. We were one of the first to adopt this screen and make it available on the most important markets. We also adopted a variant of this screen as the basis for our newsletter. Our study showed that putting the price index as primary factor increased returns, so that’s what we used to select stocks.

These screens were not the only ones, we added the Altman Z-score, Beneish score,... and many other factors that showed predictive power in different studies.

With all these screens in place, you might be wondering which ones are the most popular? Well, our stats show that during the last 3 month, our members ran 102.000 screens in total. Most screens start with selecting the 6M Price Index (28%) or book-to-market (12%) as primary factor.

What you can also see in the table above is that the Magic Formula is still very popular at 11%. The ERP5 factor is almost as popular and the VC2, which was only launched a few months ago already took 5th place. This seems to indicate that a lot of members use the trended value screen to find their bargains.

Now, 28% of the screens use the 6M Price Index as a primary factor, but what do they use as a secondary factor? Well, most people sort those results based on earnings yield.

With all these new figures and stats, what screen should you use? Well, it depends. Selecting the top 20% 6M Price Index stocks and then sorting by earnings yield seems to be the most popular choice, but we will keep all other strategies so you have the option to look at our stock universe from different angles. All formulas have been proven to be very effective so you’re bound to find excellent stocks in each one of them.