A Not-So-Good Year For the Magic Formula

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A Not-So-Good Year For the Magic Formula

By JLP | January 2, 2008

Here’s a quick look at how the hypothetical Magic Formula portfolio performed in 2007:

2007 Magic Formula Portfolio Performance

The first set of purchases did quite well. Unfortunately, every purchase after that did poorly.

I think two things affected this portfolio’s performance:

1. Value stocks did poorly in 2007 (check out this post for details on index performance).

2. Small stocks did poorly in 2007.

Since the Magic Formula portfolio is composed of mostly of small cap value stocks, it shouldn’t be a big surprise that it underperformed the market in 2007.

It’s also important to note that this portfolio was quite volatile. At one point it was up over 26% on the year.

According to the formula, I’ll sell the first set of purchases and reinvest the money on January 7th. As with any strategy, you have to accept the good with the bad. I think Greenblatt’s strategy makes sense. However, we’ll just have to wait and see how it performs over the long run. I’ll post the new stocks next week.

If you would like to read up on the Magic Formula portfolio, 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

Magic Formula Portfolio August Update

Magic Formula Portfolio October Update

Topics: Investing, Magic Formula Portfolio |

Comments to “A Not-So-Good Year For the Magic Formula”

Andy Says:
January 2nd, 2008 at 1:11 pm

Why not just buy a small cap value index fund/ETF? I suspect you’ll have very similar long-term performance with less fees and less volatility.

S. B. Says:
January 3rd, 2008 at 10:33 pm

The fact that small caps dominate the portfolio is to some degree a function of your original selection criteria when you set up the portfolio. By choosing 500MM as the minimum market cap and then just choosing only those with the very highest ROC means it is very likely you would end up with mainly small caps. To ensure large cap representation, you could have, for example, run another query with 10B as the minimum market cap and then also chosen some stocks from the top of that query.

Since the premise of the book is that ROC is a key indicator of stock performance, it is understandable that one might simply opt for a small minimum (perhaps to eliminate illiquid securities) and then simply select those with the very highest ROC. But my guess is that since there are so many more small-cap stocks than large-cap stocks, and because financial ratios and so forth of small-caps tend to have much wider ranges than large caps, it probably means that if you chose almost any single selection criterion (e.g. ROC or most anything else) and then applied it across the entire spectrum of equities and then only chose the top 10 or 20…well, you would probably inevitably end up with mostly small caps.

I’m also concerned that the 2007 performance of the portfolio looks quite bimodal. If you removed the three mining stocks — FCX, FDG, and PCU — the portfolio would be down almost 25% for the year.

On the other hand, the author of the book would claim that short-term performance is irrelevant and that, in fact, short-term and medium-term underperformance is why the system will continue to work in the long run. In other words, extended bouts of medium-term underperformance will guarantee that most adherents will eventually dismiss the “formula”, and thus the (claimed) excess return will never be arbed away.

Free Money Finance Says:
January 4th, 2008 at 5:19 am

Star Money Articles and Carnivals for the Week of December 31

Here are some recent interesting posts from the MoneyBlogNetwork and beyond as well as a list of the carnivals Free Money Finance was in this week and my posts that were included: Consumerism Commentary lists a stupid financial mistake. AllFinancialMat…

Tom Says:
March 23rd, 2008 at 10:34 am

There is one point that is missing. You are suppose to hold stocks for a year (give or take a day). The only stock you have had for a year earned 46%. The others (though I do not think they will rebound much) still have time to recoup. You are now suppose to sell your first buy and rinse and repeat. I notice on your other post you did put the new buys in your post but you left of 2,3, and 4 buy of 07.

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A Not-So-Good Year For the Magic Formula