A WINNING MAGIC FORMULA?

A WINNING MAGIC FORMULA?

This is a translation of the original article published by Nicolas Bellemare on the BourseInvestir.com web site: April 8, 2006 (Read the original paper in French here).    In November 2005, Joel Greenblatt published The Little Book That Beats the Market that very quickly became a best-seller. This book offers no less than a "magic formula" which, according to the author, would allow investors to get better-than-market returns. Based on his historical tests on a database, J. Greenblatt proclaims that his formula generated an annual yield of almost 31% from 1988 to 2004, which is almost three times the market return over the same period.    His formula is based on two main factors: return on capital and earnings yield. Return on capital is defined as a company’s earnings over 12 months before interest and tax, divided by its tangible assets. The earnings yield is the earnings divided by the share price plus debt. What is interesting about his formula is that it uses known factors that lead to success on the stock market. As the author explains, by using the formula, we usually end up with good companies at a good price.    Many investors would be skeptical if presented with an investment strategy as simple as that. And they should be. All you need to do is look at some previously published books of the same kind to realize that "magic formulas" are not so magical after all. For instance, the Dogs of the Dow strategy, which consists in buying the 10 stocks with the highest dividend yield on the famous Dow Jones index, has produced very poor returns these last years. And yet, it is widely advertised as having generated an annual return of 17.7% since 1973! Another classic example is the one of the famous money manager O’Shaughnessy who, in 1996, published a book titled, What Works on Wall Street. It recommends buying 50 stocks with a good price momentum, increased profits over 5 consecutive years and a price/book ratio of lower than 1.5. These criteria, like Greenblatt’s, are well-known in fundamental analysis. From 1954 to 1994, this strategy would have generated a yield of 18.2%. Enthusiastically, O’Shaughnessy patented his selection method and launched his mutual funds based on his "proven over time" strategy. The result: his funds under-performed the market during their early years. Two of them were eventually shut down and he resigned from the board of the others.    Why don’t these formulas work? In my opinion, there are two factors. Once the strategy is commonly known, it loses its predictive power because a lot of people rush to buy the mentioned stocks, thereby inflating stock market prices. The second factor is that a mechanical strategy such as these usually favors one or a small variety of companies. For instance, the Dogs of the Dow builds a portfolio holding only big American capitalizations. Those stocks have recently under- performed. Who’s to say if they will generate the same returns from 2000 to 2005 as they did from 1950 to 2000? From decade to decade, the economy can change noticeably. The formula in The Little Book That Beats the Market, basing its selection on return on capital, entails finding companies that generate money with few assets, like the service sector or light manufacture sector. 1988 to 2004 were good years for this kind of company, but will the future continue to favour companies from the industrial manufacture, financial services and public services sectors? Herein lies the weakness of magic formulas.    In summary, J. Greenblatt's book offers interesting ideas about the use of key fundamental criteria like return on capital and earnings yield. However, applying the magic formula far from guarantees that you will get extraordinary returns. To satisfy your curiosity, I will conclude here with the list of the stocks with a market capitalization of more than $1 million, having the best rating according to the magic formula found on the book’s official web site, www.magicformulainvesting.com. Company Name Ticker Alon USA Energy ALJ American Eagle Outfitters AEOS Angiotech Pharmaceuticals ANPI Arbitron ARB Block (H&R) HRB CGI Group GIB Check Point Software Technologies CHKP Deluxe Corp DLX EarthLink ELNK Freeport-McMoRan Copper & Gold FCX Frontier Oil Corp. FTO Harland (John H.) Co JH Hasbro HAS Holly Corp HOC Intel Corp INTC King Pharmaceuticals KG Kos Pharmaceuticals KOSP Marvel Entertainment MVL Mattel MAT NS Group NSS Nu Skin Enterprises NUS Timberland Co (The) TBL UST UST Valassis Communications VCI Yankee Candle Co YCC    Nicolas Bellemare