How “Magic” is the Magic Formula?

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The underlying concept of the magic formula is a genius marketing platform, but it is unclear how “magic” the formula actually is–examine ‘cheapness,’ examine ‘quality,’ combine the analysis and buy the best value (get the most bang for your buck). The magic formula identifies quality via EBIT / (NPPE +net working capital) and cheapness via EBIT / TEV. These two measures are certainly not ‘bad’; however, they are also not necessarily optimal.

We are always exploring alternatives to the magic formula found in the academic literature. In fact, we highlighted the ‘academic version’ of the magic formula in the following post:

http://blog.empiricalfinancellc.com/2011/02/the-other-side-of-value/

The “profit and value” strategy identifies cheapness via book-to-market, and identifies quality via gross-profits-to-total-assets.

Next, we backtested the magic formula and the profit and value system and compared them in a head-to-head battle. We tested a portfolio that is annually rebalanced on June 30th (only stocks >80% NYSE market cap breakpoint are included). The portfolio is rebalanced across 30 stocks on July 1st and held until June 30th.

First the Drawdowns:

Very similar, with a slight edge for profit and value.

Next, the overall performance:

Again, slight edge for profit and value, but very little overall difference.

And how about the year by year comparison?

Honestly, looks like a pretty even match–amazingly similar!

Key Takeaway:

Focusing on quality and cheapness simultaneously helps investors beat the market

However…

THE MAGIC FORMULA AIN’T THAT MAGIC!

Additional study…

Here is a document with the summary results of the comparison between profit and value and the magic formula for broad market (as defined as market cap >20% breakpoint on the NYSE) and for large caps, exclusively (as defined as market cap >80% breakpoint on the NYSE):

Download (PDF, 588.83KB)

Key Takeaways:

1) Profit and value is arguably better than the magic formula

2) Both strategies have significant risk in the form of large drawdowns.

3) Long/short systems based on quality/cheapness factors are DANGEROUS!

Recommendation:

Explore the use of quality/cheapness factors for long-only investment systems, but be prepared for a very volatile ride.

If you are interested in trading either system, head to Empirical Finance Data. We do all the calculations, so you can try and make some money.

 

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