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The Magic Formula Suffered a Huge Blow to the Gut!

By JLP | August 7, 2007

The Finance Buff’s post Magic Formula Investing: Will it Work? reminded me that I needed to give you guys a portfolio update.

Many of you know that I have been tracking a hypothetical portfolio that follows the advice recommended in Joel Greenblatt’s The Little Book That Beats The Market (Affiliate Link). For more information, see the posts listed below.

At one point this year the portfolio was up over 26%. That was BEFORE the market tumble of the past few weeks that hit the portfolio so hard as to render it nearly unconscious:

Magic Formula Investing Portfolio Update

So, I think we can gather from the graphic that this strategy is not for the faint of heart. I would recommend that you put only a fraction of your money in this strategy or change up the formula by allowing it choose companies with higher market caps (for this portfolio my market cap threshold is $500 million, which is rather low).

Also, it’s important to point out that not all of the money was invested at the same time. Following the procedure laid out on MagicFormulaInvesting.com, I did four separate purchases of $2,500 each ($500 per stock):

January 5, 2007 Purchases:

FreightCar America Inc (RAIL)
Aspreva Pharmaceuticals Corp (ASPV)
Freeport-McMoran Copper & Gold Inc. (FCX)
OmniVision Technologies Inc. (OVTI)
Fording Canadian Coal Trust (FDG)
Performance of the group since purchase: 25.00%

March 27, 2007 Purchases:

Teck Cominco Ltd. (TCK)
JAKKS Pacific Inc. (JAKK)
King Pharmaceuticals Inc. (KG)
K-Swiss Inc. (KSWS)
Labor Ready Inc. (LRW)
Performance of the group since purchase: -1.23%

May 1, 2007 Purchases:

Kelly Services Inc. (KELYA)
Steven Madden Ltd. (SHOO)
Southern Copper Corp. (PCU)
USA Mobility Inc. (USMO)
Western Refining Inc. (WNR)
Performance of the group since purchase: 4.60%

July 9, 2007 Purchases:

ViroPharma Incorporated (VPHM)
Biovail Corporation (BVF)
American Eagle Outfitters (AEO)
Frontier Oil Corporation (FTO)
Lam Research Corporation (LRCX)
Performance of the group since purchase: -12.35%

To read up on the strategy and follow along, check out these posts:

A Look at Magic Formula Investing

Magic Formula – Portfolio Update

Magic Formula Investing Update – 2nd “Purchase”

Magic Fomula Portfolio April Update

Magic Formula Portfolio May Update

Magic Formula Portfolio July Update

Topics: Investing, Magic Formula Portfolio | 14 Comments »


14 Responses to “The Magic Formula Suffered a Huge Blow to the Gut!”

  1. The Unknown Professor Says:
    August 7th, 2007 at 2:27 pm

    The Magic Formula selection procedure is essentially a small-cap value strategy. Given that, your results aren’t surprising. The earlier runup was likely driven at least in part by some of the P-E activity we’ve seen (low multiple companies with good ROI are traditional takeover/going private targets). So, the slowdown in PE activity probably let some of the bubble out of these stocks. In addition, I’d expectect small-cap value to be a bit more volatile in most time periods.

    Not that that’s a bad thing – just something to be aware of.

  2. Rob Says:
    August 7th, 2007 at 3:18 pm

    The overall return and volatility are also being hit by the staggerred buying, as you were only partially invested when the market went up but were fully invested right at the downturn. This will smooth out over time. I would be interested in seeing what the year-to-date return would have been if you bought everything at once.

  3. JLP Says:
    August 7th, 2007 at 3:24 pm

    Rob,

    I thought about that but it would be hard to calculate since some of the stocks probably wouldn’t have shown up in the results at the beginning of the year. I suppose I could go back and look at the initial list and see how the 10 stocks from that list would have performed.

  4. plonkee Says:
    August 7th, 2007 at 4:10 pm

    Presumably the hope is that over the long term this will prove to be an interesting strategy and so the short term performance isn’t that important?

  5. Don Says:
    August 7th, 2007 at 4:46 pm

    Even in the book they point out that there will be long stretches when the magic formula under-performs. No surprise there.

  6. Esmo Says:
    August 7th, 2007 at 4:52 pm

    You can see the initial prices on Yahoo Finance Historical Prices and create a spreadsheet that way. A year’s performance is really not evident of this strategy though – I’d take at least 5 years or 10 years in up, down, and up/down periods to really measure this strategy’s effectiveness.

    You also want to measure against other investment strategies to look at the Magic Formula’s effectiveness – I’m sure a lot of funds lost a lot of money in the past couple weeks (and for 2 of Bear Sterns’ hedge funds, a little more than a lot).

    It’s really hard to measure the effectiveness of a strategy, so you might as well buy index funds and focus on asset allocation.

  7. Driac Says:
    August 7th, 2007 at 11:01 pm

    Esmo has it right. For you to extrapolate anything from 6 months of behavior in the market is premature. You need to evaluate stock performance over 5, 10, 15 years. Give it some time, and stop watching to see the pot boil. It’ll get there on its own.

  8. JLP Says:
    August 7th, 2007 at 11:14 pm

    Esmo and Driac,

    Of course I know this. I guess I didn’t address it in the post.

  9. Jon Says:
    August 8th, 2007 at 12:02 am

    I read the book “Little Book that Beats the Market” and tried the investments, but my concern is that it removes the “human” decision about a stock… Is it a good investment or not, that a decision to make about the product or service, the market, and the management. It falls short of Warren Buffett’s investing strategies.

    v/r
    Jon
    Make Money Jot

  10. Andy Says:
    August 8th, 2007 at 1:39 am

    I don’t see how this is any better than buying a small cap value index fund. You are certainly getting more volatility and almost certainly aren’t getting any better returns.

  11. Brad Says:
    August 8th, 2007 at 10:44 am

    Jon–

    For many investors, removing the human element (freak out during a down turn, buy buy buy when everyone feels great) would be a very good thing! :-)

  12. JLP Says:
    August 8th, 2007 at 12:46 pm

    Andy,

    I think over the long run the strategy will work just fine. I was just surprised at how fast it fell.

  13. JLP Says:
    August 8th, 2007 at 12:55 pm

    Andy,

    One other thing, I just checked the performance of the iShares S&P SmallCap 600 ETF (IJS). Through June 29, it had returned 6.36% while the Magic Formula was up 21.13%.

  14. Free Money Finance Says:
    August 10th, 2007 at 5:19 am

    Star Money Articles for the Week of August 6

    Here are some recent interesting posts from the MoneyBlogNetwork and beyond: Consumerism Commentary discusses accepting a counter-offer. AllFinancialMatters notes that the magic formula isn’t so magical. MightyBargainHunter gives another good reason t…

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