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Question about Greenblatt's Magic Formula

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asked Oct 16, 2017 01:20 PM by
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Hi Jin,

I was wondering whether you've heard of the Magic Formula created by hedge fund manager Joel Greenblatt, wherein companies are ranked exclusively on high earnings yield and high return on invested capital. Some backtests -- including ones performed by the asset management firm behind QVAL and IVAL -- seem to suggest that Greenblatt's formula works. I'm considering allocating a subset of my portfolio to about 20 MF stocks, but I wanted to get your opinion first.

Thanks in advance.

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answered Oct 18, 2017 12:34 AM by
Jin Won Choi gravatar image Administrator

Hi Burt,

I'm familiar with the formula - I had read Greenblatt's book on it some years ago. The formula recorded some impressive returns until the 2000s. But since then, as with many other quantitative value investing strategies, it has failed to perform.

There are two possible explanations for the recent underperformance. One explanation is that such strategies tend to go through rough patches which sometimes stretch a decade or more, and that we're just going through one of these patches. If so, the strategy should perform again soon. The other explanation is that the proliferation of computers has "arbitraged" away any advantage of such strategies. If this is the case, the magic formula would never work again.

It's very difficult to know which of these explanations is correct. Personally, I think they're both partially correct. In other words, I think the magic formula will work to some extent going forward, but perhaps not to the same extent as it did before the 2000s.

Finally, if you already invest in QVAL, I'd think carefully about how much to allocate towards the magic formula. QVAL and the magic formula have some similarities, so you may find yourself investing in the same stocks twice.

Jin

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Thanks again for the response, Jin. By the way, I just checked the holdings for QVAL, and no less than 8 of the 41 holdings are magic formula stocks that I was just about to buy. The similarity between QVAL and the magic formula is something that I'll have to take into consideration.

Burt_Macklin ( Oct 19, 2017 11:08 AM )edit

My pleasure. I hope your strategy works out!

Jin Choi ( Oct 21, 2017 11:04 AM )edit
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answered Oct 23, 2017 12:27 PM by
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As a complimentary note, here is the link to Jin's 2015 review of the book. https://www.moneygeek.ca/weblog/2015/...

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Thanks for posting, but just wanted to note that I didn't write the review - it's written by a contributor named Najim.

Jin Choi ( Oct 24, 2017 10:33 AM )edit
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