Here's A Practical Strategy For Using the MagicDiligence Spells
Since we started the Spells model here at MagicDiligence almost a year ago, one question has been asked of me more frequently than any other:
How can an investor use the Spells in a practical investing strategy?
It is, of course, an excellent question. Today, for the first time, I want to introduce our Spells Tracking Portfolios, which provides a mechanical strategy for realistic investing with the Spells, and also provides us a firmer basis for long-term performance calculation against the S&P 500.
Lets take a look of some facets of this new addition to the site.
MagicDiligence was originally based on the findings of Joel Greenblatt's Magic Formula Investing (MFI) strategy, as he described in his 2005 book The Little Book that Beats the Market.
In that book, Mr. Greenblatt laid out a strategy that prescribed buying a number of positions every quarter from a screen of stocks ranked by composite earnings yield and return on capital metrics ("the least expensive, most efficient companies in the market"). These stocks are held for one year and then sold to make room for a new batch of stocks, rinse and repeat. He found that this strategy dramatically outperformed the stock market over a period of 17 years.
Piggybacking off his results (the Magic Recipe Spell is based off of the MFI prescription), our Tracking Portfolios will follow a nearly identical mechanical strategy. Succinctly:
- Purchase 5 equal weight positions from the spell every 3 months (3 positions for Star List).
- Hold for one year.
- At end of one year, sell positions. Using proceeds, buy 5 new equal weight positions.
- Repeat from step 2.
This will give us 20 stocks purchased throughout the year, a good sized portfolio. The Star List often has very few stocks, so I've limited the "tranche" size to 3 stocks, and even that isn't possible to fill sometimes. I have some more thoughts on the Star List below - put simply, I do not believe it will work very well for a mechanical strategy.
I've gone back and applied this strategy for 2016, using random picks starting on the date the Spells were launched (2016-02-19), and buying a new group every 3 months. To get a good estimate of the general result of this strategy, I produced 20 tracking portfolios for each Spell. The tracking portfolios summary page (also available under the "Spells" menu) shows the aggregate performance for the 20 portfolios, that performance vs. the S&P 500 tracking portfolio, and how many of the individual portfolios exceeded the performance of the S&P ("hit rate"). You can expand each of the Spells and click the links to see the details for each of the individual portfolios if you wish. Also, you can select performance range from the drop-down at top, limiting the results to a particular year or seeing the results from inception. The performance numbers will be updated at the end of each month.
MagicDiligence will also use these results as our new long-term performance metric. Previously, we had used daily compound performance of the Spells. While correct algorithmically, many of you pointed out (and I agree) that matching that performance would be practically impossible because of the frequency of trading required. Now, we will have performance measurements that are practically achievable by pretty much any investor.
Comments on 2016 Performance
As you may probably expect, the tracking portfolios did not exhibit as robust a performance as the day-to-day compound results. That said, all 3 of the Magic Recipe, Deep Value, and Quality Growth tracking portfolios outperformed the S&P 500, in the aggregate, in 2016. The Deep Value spell was notably impressive, with all 20 of its portfolios outperforming the S&P 500 by an average of 8.5%.
I mentioned above that the Star List is probably not going to work particularly well in this portfolio strategy. Indeed, following the mechanical buy/sell paradigm, its 20 portfolios underperformed the S&P 500 by 4%, with only 7 of 20 outperforming. That's a far cry from the substantial market-beating performance we measured on a day-to-day compound basis. There are 2 main reasons for this:
- The screen just doesn't have enough stocks to build a diversified portfolio. Mechanical strategies rely on the law of averages, which require a hefty sample/portfolio size. For many days in 2016, the Star List screened less than 5 stocks!
- High turnover was a key reason for the Star List's strong performance. Stocks frequently entered and exited the list based on day-to-day gyrations in their (often very volatile) stock prices. An infrequent trading strategy such as we outlined cannot take advantage of this.
For now, I am going to continue to track the Star List in this manner, but I don't recommend using this portfolio strategy with Star List at this time.
I hope the tracking portfolios and their simple strategy help provide a grounded blueprint for using our Spells to outperform the market. It was something that was lacking from the idea of the Spells, and our longer-term performance tracking was not replicable by an average investor. We've attempted to remedy both of these issues now and can move forward to beat the market using practical, mechanical strategies with time-tested and proven stock screening and ranking criteria!
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