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Updated daily. All values annualized from Jan. 2008.

This article was updated 8/18/08 at 2pm EST to account for splits and dividends within the MFI screen. The change in overall results is minimal.

Can you prove that MagicDiligence is better than following the Magic Formula strategy unaltered?

While not in so many words, this is the question that is on many reader's minds, both members and non-members. It is a question in my mind as well. Joel Greenblatt, in The Little Book that Beats the Market, says that the strategy's 30%+ return was an average. He makes no bones about the fact that those following the strategy as prescribed would buy losers - sometimes big losers. But, buying blindly yielded a great average annual return. The point of MagicDiligence was to do research to weed out the stocks that brought the average down, by looking for strong competitive advantages, good financial health, etc. I fully expected this approach to avoid some of the big losers, but I also knew that it would cause MD to miss some big, unpredictable winners. However, the net outcome should outperform the unfettered strategy.

So, at this point the MD recommendation portfolio has performed well against the benchmark, the S&P 500 ETF "SPY". But how has it done against the Magic Formula screens themselves? Would investors have done as well (or better) by simply following the strategy of random selection off the MFI screen?

Before I get to the results, let me explain why the Magic Formula screens are not good benchmarks. In investing, you want to benchmark against an achievable alternative goal. For nearly all mutual funds and newsletters, that benchmark is the S&P 500. This is the case for 2 reasons. First, the S&P 500 represents the vast majority of the U.S. stock market - over 70%. Second, it is very easy to duplicate the S&P 500's return through indexed mutual funds or ETFs.

It is virtually impossible for an individual investor to duplicate the return on the complete Magic Formula screen. For example, MagicDiligence uses two MFI screens - 100 over 50 million market cap, and 50 over 2 billion. To duplicate the returns of these, the investor would have to buy all 100 or all 50 stocks on those screens in a single day. There are no mutual funds or ETFs to make this possible.

This said, the point of the site is to improve the Magic Formula, and we all want to know if that's being achieved. MagicDiligence only has MFI screen records back to March 13, so some picks are not included. Using the new MFI Historical Performance Tool (free trial), here are the results:

vs. Screen	Screen	MagicDiligence	Diff	% MD Picks Outperforming
100 > 50 million	6.03%	9.82%	+3.79%	73%
50 > 2 billion	0.08%	9.82%	+9.74%	82%

MagicDiligence picks have significantly outperformed the average return of both screens, and at good accuracy rates. Doing due diligence and picking only the best companies in the screen seems to be adding value to the strategy... so far!

It's interesting how wide a performance gap there has been between the small-cap screen and the large-cap screen. This seems to lend support to Greenblatt's results of about 10% better annual performance by including small cap stocks. This likely adds volatility to returns as well.

Lastly, I thought it would be interesting to list some of the Magic Formula's "Greatest Hits" in the past 5 months... as well as some of the value traps it has dug up!

Greatest Hits

GHM - Graham Corp	up 174%
HIRE - HireRight	up 110%
CSGS - CSG Systems	up 73%
CRDN - Ceradyne	up 62%

Value Traps

CROX - Crocs Inc	down 78%
BWLRF - Breakwater Resources	down 76%
IAR - Idearc	down 72%

Steve owns no position in any stocks discussed in this article.

Calculate Magic Formula statistics for any stock with the MFI Stats Calculator tool.

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Comments

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Posted by jschutte on 2008-08-18 05:14:31

That's some good outperformance, but from reading The Little Book That Beats The Market, it seems that the true magic formula is the best 30 stocks, regardless of market size.

So the top 25 screen with a minimum capitalization of 1 million would be a more accurate comparison to the real magic formula than 100 over 50 million or 50 over 2 billion.

Do you have those numbers?

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Posted by Steve on 2008-08-18 05:30:37

Greenblatt has said in a few interviews that statistically there is no difference between the top 25 and the top 100. All of these stocks would fall into the top stepped ranking he details in the book. Unfortunately, MD only tracks 2 of the MFI screens, but I believe the performance against the top 100 is a good proxy for comparing to the unfettered MFI strategy.

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