Content
Stocks

MagicDiligence vs. Magic Formula

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. ScreenScreenMagicDiligenceDiff% MD Picks Outperforming
100 > 50 million6.03%9.82%+3.79%73%
50 > 2 billion0.08%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 Corpup 174%
HIRE - HireRightup 110%
CSGS - CSG Systemsup 73%
CRDN - Ceradyneup 62%

Value Traps

CROX - Crocs Incdown 78%
BWLRF - Breakwater Resourcesdown 76%
IAR - Idearcdown 72%
Get our stock reviews and other Magic Formula focused content delivered FREE to your inbox. Sign up for the MagicDiligence Newsletter! For a limited time, you'll also get the FREE report, 5 Quick and Easy Tips for Improving Your Stock Picks!
Get Your FREE Report Now

We will NEVER give out your email address. Period.

Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

© 2008-2014 Alexander Online Properties LLC

Comments

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?

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.

Log In to Comment