Magic Formula vs EBIT yield portfolio
(update June 2016)

Back in January I started a test of three different investment strategies to see which one would perform the best in 2016 (see Magic Formula vs EBIT Yield for more details). Each portfolio was based on £100,000 equally invested across 20 different UK shares from different sectors of the stock market.

I wanted to see how some rules-based investment strategies based purely on numbers without any further research or forecasts would perform over the short and long run. On top of that, I also wanted to make the tests as realistic as possible and include the costs of trading that all real investors have to pay. Many studies of investing strategies ignore them and in doing so can give a false impression as to how effective they really are.

The three strategies that were put to the test were:

  1. A simple Magic Formula portfolio based on Joel Greenblatt's book The Little Book that Beats the Market. This strategy is based on picking the shares of good quality companies at relatively cheap prices based on a ranking system (For more on Magic Formula investing click here).
  2. A more tailored Magic Formula portfolio. Here, the selection of companies and their shares takes into account the existence of hidden, off-balance sheet debts (see A more thoughtful approach to Magic Formula investing).
  3. A portfolio where quality is ignored altogether and is based on cheapness instead. Shares are ranked on the basis of their trailing EBIT yield using the last reported annual profits. The EBIT yield also takes into account hidden debts (i.e. it was lease-adjusted.

I have not looked at these portfolios for five months so I thought it was time to revisit them and see how they are getting on. Personally, I don't place too much importance on short-term results but I thought it would be interesting to see how the experiment was progressing nonetheless.

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The results so far

These results were based on the performance of the portfolio from the close of trading on 7th January 2016 to 11.10 am on 7th June 2016 (to be exact) when I took some screenshots from SharePad. The performance includes the costs of trading (commissions, stamp duty and bid-offer spreads) and dividends received. There has been no additional buying or selling of shares.

So have these portfolios made money? Have they performed better than the stock market as a whole as measured by the FTSE All Share Total Return Index?

The market has actually done quite well with a total return of 7.28%. 62% of the shares in the FTSE All Share index have made money with 38% of them losing money. The first five months of the year have rewarded investors who were prepared to go against the crowd and buy very unloved mining and oil companies where there have been some stellar gains so far.

Top 10 best performing shares 07/01/16 to 07/06/16
TIDMNameTotal Return
HOCHochschild Mining PLC240%
LMILonmin PLC190%
AALAnglo American PLC190%
PMOPremier Oil PLC120%
ENQEnQuest PLC91%
GLENGlencore PLC83%
ACAAcacia Mining PLC80%
DRTYDarty PLC71%
EVREvraz PLC71%
VEDVedanta Resources PLC69%

This shows the stunning impact that concentrated, contrarian investing in a particular sector can have on a portfolio when things go well. Of course, most people don't invest this way. They tend to spread their investments across different sectors so that they don't have all their eggs in one basket. It's just as easy to make big losses with big sector-specific bets as well.

Good investing is just as much about avoiding the bad stuff as well as picking winners. Below are the top ten howlers for the year so far:

Top 10 worst performing shares 07/01/16 to 07/06/16
TIDMNameTotal Return
SEPUSepura PLC-65%
LAKELakehouse PLC-60%
SIVSt Ives PLC-53%
CMBNCambian Group PLC-46%
RTNRestaurant Group (The) PLC-45%
GMSGulf Marine Services PLC-40%
FLYBFlybe Group PLC-39%
TCGThomas Cook Group PLC-39%
COBCobham PLC-39%
MTCMothercare PLC-38%

Many of the companies above have issued profit warnings which have decimated investor returns so far.

Let's have a look at our three separate portfolios:

Simple Magic Formula

07/01/16 to 07/06/16
Starting Cash£100,000
Cash invested in shares£99,264.66
Portfolio Value£103,575.96
Total Return3.58%
Total Return on cash invested4.34%
FTSE All Share7.28%

No of winning shares

12
No of losing shares8

This portfolio has not done as well as the market. Excluding dealing costs, it has delivered a total return of 4.34% on the £99,264.66 that was invested in shares. This falls to 3.58% once dealing costs are included. That's not brilliant but it's still better than having cash in the bank if that's any comfort.

The portfolio has had more winning shares than losing ones. The notable winners are shown below.

Biggest winnersTotal Return
GVC Holdings28.50%
Halfords28.00%
Rotork19.90%

There have not been any disasters either.

Biggest losersTotal Return
RM-18.70%
Independent News & Media-17.60%
Ophir Energy-13.90%

Lease-adjusted Magic Formula

This portfolio has not performed much better. So far, moving away from Joel Greenblatt's simple calculations of ROCE and EBIT yield by including items such as pension deficits and hidden debts has not produced superior results.

07/01/16 to 07/06/16
Starting Cash£100,000
Cash invested in shares£99,240.04
Portfolio Value£103,799.27
Total Return3.80%
Total Return on cash invested4.59%
FTSE All Share7.28%

No of winning shares

13
No of losing shares7

There's been one more winning share and one less losing share than the Simple Magic Formula portfolio.

Biggest winnersTotal Return
Ferrexpo42.70%
GVC Holdings28.50%
Rotork19.90%

Again there haven't been any major disasters.

Biggest losersTotal Return
RM-18.70%
Ophir Energy-13.90%
Hvivo-12.40%

EBIT yield - is just cheap best?

Wesley Gray, an American expert when it comes to valuing shares and investing by numbers has argued that picking shares with high EBIT yields alone and ignoring quality measures such as ROCE can deliver better results.

So far in 2016, this has proven to be true. A lease-adjusted EBIT yield portfolio has performed better than a Magic Formula one but it has still performed worse than the market as a whole. The total return on cash invested so far has been 5.59%. When dealing costs are included this falls to 4.78%.

07/01/16 to 07/06/16
Starting Cash£100,000
Cash invested in shares£99,233.51
Portfolio Value£104,784.72
Total Return4.78%
Total Return on cash invested5.59%
FTSE All Share7.28%

No of winning shares

12
No of losing shares8

The strategy has been quite successful in picking some big winners from shares that were very unloved by investors back in January. Drax, Ferrexpo and Stock Spirits Group all seemed to have a lot of problems and uncertainty surrounding their future prospects. They were probably the kind of shares that lots of investors would have been scared of owning.

Biggest winnersTotal Return
Drax43.60%
Ferrexpo42.70%
Stock Spirits Group29.20%

As with the two Magic Formula portfolios, the EBIT yield portfolio has kept away from the shares in the FTSE-All Share index that have posted very big losses.

Biggest losersTotal Return
RM-18.70%
Abbey-18.50%
Independent News & Media-12.40%

What have we learned?

  1. Five months is too short a time to properly assess whether an investment formula is good or bad.
  2. Investment strategies don't beat the market all the time.
  3. Costs matter. In the early stages of a portfolio the effect of dealing costs can have a significant negative impact on portfolio performance. These become less significant as time goes on - providing you don't keep on buying and selling lots of shares.
  4. Concentrated bets in particular sectors can deliver very impressive short-term results. The pure Magic Formula approach of Greenblatt suggests a portfolio of 10-30 shares. However, he does say that 5-8 shares from different industries can deliver good results if you understand what you are buying. Perhaps running portfolios with 20 shares from different sectors dilutes performance too much?
  5. Taking the emotions out of investing and basing decisions on numbers alone can produce a portfolio which contains unloved shares that can then make a lot of money. Whether these are good enough to produce a market-beating performance for the total portfolio is less clear.
  6. Focusing on valuations alone and picking the cheapest shares based on their EBIT yield has delivered better results so far. Is quality overrated as an investment criteria?

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