Magic Formula versus FTSE 100
Two crashes and two bull markets in a day
After a day (and part of a night) exporting data from Sharelockholmes, ranking it, and creating portfolios from the top 30 companies using two variants of Joel Greenblatt's magic formula, I’d built a monster: 133 individual worksheets, 80 portfolios (40 for each variant of the magic formula), one chart, and a serious case of number blindness.
Constructing it reminded me of painting windows, a job I detest, because it takes days, it's interminably repetitive and one mistake and you're in a world of pain cleaning half-dried paint from glass. Sometimes it goes well, and sometimes it goes badly, and even in these most mundane of tasks, you feel desperation and elation. There's got to be a better method than building up a picture of the performance of the magic formula one portfolio, one quarter year, at a time.
At first I was elated, incredulous even, because I was fresh at the task and the early portfolios trounced the FTSE 100, sometimes by over 40%. Then dejection set in as portfolio returns fell below 10%. When three consecutive portfolios did significantly worse than the market during the crash of 2008 I began to feel desperate, questioning the formula, the data, my own unsteady hand, and finally I felt relief as the portfolios performed well in the subsequent recovery.
Doing quantitative analysis in my naive fashion, puts you through the wringer. I lived through a decade of investing, two crashes and two bull markets, in a day and for that reason I recommend the experience. After all, if you are to follow a strategy like the magic formula (and I do for Money Observer magazine), and more importantly stick with the strategy, these are the emotions you must ignore.
After all that, Graeme tells me it's not enough. I need to test over multiple ten year periods.
Well he's right, but in my defence I only have ten years of data as opposed to the vast databases available to serious researchers and City folk, and I'm not an academic I'm an investor and blogger which means the opportunity costs of rigorous research may be higher because I've got to get on and write and invest. These results might be useful but they're not Gospel.
One final caveat: Not only did I sort each portfolio individually, but I had to calculate the relative performance of each company that delisted in the course of a year so the potential for human error is high, and I intend to take another look at the data when the blindness has receded.
Here's the chart:
You'll need to click on it to get a full sized version (and if anybody knows how to make fatter bars in Excel, please let me know!).
The good news is the green lines are positive far more often than they are negative and many of the positive bars are significantly longer. In other words the magic formula beat the market, as measured by the FTSE 100.
The light green lines show the performance of what I call the Alt-MF (alternative magic formula), which uses Return on Assets (described at the end of this blog) as a measure of quality. The dark green lines show the performance of the traditional magic formula, which uses Return on Capital.
Joel Greenblatt, inventor of the magic formula favours ROC and I assume that he tested both and found ROC did better. I can't get hold of UK data that calculates ROC his way though, and I'm suspicious of the calculations used by UK data providers. Since Greenblatt proposes ROA as the best substitute for ROC I hoped the test would show that using ROA in the UK wouldn't disadvantage investors.
My test suggests it doesn't. The mean Alt-MF portfolio, which use ROA, beat the market by 13%, while the mean MF portfolio beat the market by 12%. I don't think the difference is significant, and broadly speaking the two portfolios prospered at the same time, and disappointed at the same time.
So I got the result I wanted!
But there are a couple of loose ends:
- I tested companies valued by the market over £500m, so the total pool of companies from which to pick the top 30 varied. The most was 288 in March 2007, and the least was 155 in March 2003. On average all companies worth over £500m beat the index, by about 4%. I say about, because I haven't gone back and filled in the missing returns for companies that delisted each year unless they were in the top 30. The performance of delisted companies could make a difference, although it didn't to the average return of all forty portfolios of each variant of the magic formula.
Assuming this figure is right, the magic formula portfolios beat their peers by 8%-9%, less than the 12%-13% they beat the index by. That's probably because the index is weighted. The biggest companies of all have a bigger influence on its performance, whereas many of the companies in my samples are too small for the FTSE-100 and they're equally weighted. Using the FTSE-350 as a benchmark would help a little (although that contains even smaller companies than in my sample, and it's still weighted by market capitalisation).
Only six of the Alt-MF portfolios did worse than the FTSE 100, and they didn't do much worse. Against the peer-group of companies valued at over £500m, the strategy underperformed on 12 occasions so its even more dependent on a few years of very strong performance. Since the peer group is probably a better benchmark, I probably ought to clean up the data and check the results.
- The extraordinarily good performance of the strategy during the crash between 2000 and 2003 is a mystery as Greenblatt found the magic formula beats bull markets handsomely and does marginally less well than the market during bears.
- I'd like to add back the return of the FTSE 100 to get the absolute return of the portfolios (but it means calculating the FTSE’s return for most of 40 one year periods). I'd also like to calculate the performance of the lowest ranked companies but that means creating eighty more portfolios. I'm not sure I've got the energy!
Comment, or send me an email if you'd like to see the spreadsheet.
It's a big download.
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