Filtering: Magic Formula vs EBIT yield - which strategy will win in 2016?
One of the things that makes stock market investing so interesting is that there are lots of different ways to try and make money. There's no shortage of strategies out there backed up with lots of data telling you how good they have been in the past.
That's all well and good but what investors really want to know is are these strategies any good today? No-one really knows the answer to this question so we've decided to set up some tests.
What we are going to be doing over the coming weeks and months is to put some popular investing strategies - and some of our own - under the microscope and see how they perform in the real world of the private investor. We'll revisit them on a monthly basis to see how they have been getting on.
Using the filtering tools in ShareScope and SharePad we will select a number of different portfolios that fit the criteria of a specific strategy. The focus will be on testing a portfolio that a private investor could reasonably be expected to buy rather than following the rules of an academic study which can often be impossible for them to do.
Here's how we intend to go about this:
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The building blocks of test portfolios
- Each portfolio to contain 20 shares. It becomes harder and more expensive to own a lot more.
- £5,000 to be invested in each share to give a total investment of £100,000 - a nice number to measure future performance.
- Each share to come from a different sector of the stock market to reduce risk.
- The portfolio will be held for one year. There will be no buying and selling of shares or rebalancing of the portfolio in between.
- The performance of the portfolio will be measured on an offer (buying price) to bid (selling price) basis plus dividends received.
- Performance will be measured after taking away the costs of running the portfolio such as broker commissions (£10 per share), stamp duty (around £25 per share at 0.5%) and bid-offer spreads (the difference between the buying and the selling price of the shares).
- The benchmark for each portfolio is the FTSE-All Share Total Return Index.
Before we begin
The important thing to remember is that we will largely be looking at strategies based on a set of rules. There is little or no investment analysis going on here. Also, the portfolios are just experiments. Do your own research before buying any share that comes from a filter.
In many cases, there will be no profit forecasts involved. Shares will be selected on the basis of their most recent results or historic average results. This might mean that shares of companies where future profits are expected to fall might be chosen.
The strategy ultimately wins or loses based on the quality of its rules and what goes on in the general stock market as a whole.
Let's get on with the first test.
A version of Joel Greenblatt's Magic Formula.
I wrote about this strategy last month (A more thoughtful approach to Magic Formula investing) and think it is probably one of the most simple and powerful stock market strategies out there. You are supposed to beat the stock market by buying the shares of good companies at reasonable prices.
As I mentioned in my article, I have a few reservations about the basic version of Greenblatt's Magic formula. In short, I think it might be too simple as it ignores significant company liabilities such as pension fund shortfalls and hidden debts from rented assets such as buildings and equipment. (Click here to read more about hidden debts.)
This means that the simple version might lead you to think that a company is good (it has a high ROCE) when it isn't. Or you might think it is cheap (it has a high EBIT yield) when it isn't really.
SharePad allows users to rank companies using a variant of the Magic Formula which gets around these problems. It uses a lease-adjusted EBIT yield and ROCE (see the recent article for more about this).
Lease-adjusted Magic Formula portfolio
For this portfolio, we used SharePad's lease-adjusted Magic Formula column to rank the shares listed on the stock market. The Magic Formula only ranks companies with a market cap of £100m or more. Starting from the top, we have selected the first 20 shares in different sectors. This portfolio was selected on 7th January 2016.
| TIDM | Name | Rank | MCap (m) | Lease-adj ROCE | Lease-adj EBIT yield | Subsector |
|---|---|---|---|---|---|---|
| HVO | Hvivo PLC | 1 | £168.50 | 76.4 | 38.7 | Biotechnology |
| INDV | Indivior PLC | 2 | £1,267.60 | 375.8 | 23.4 | Pharmaceuticals |
| OPHR | Ophir Energy PLC | 3 | £623.50 | 37 | 374.6 | Exploration & Production |
| CAML | Central Asia Metals PLC | 4 | £161.40 | 40.3 | 33.8 | General Mining |
| GTLY | Gateley (Holdings) PLC | 5 | £107.40 | 106.6 | 16.9 | Business Support Services |
| WIZZ | Wizz Air Holding PLC | 7 | £1,004.70 | 36.2 | 17.6 | Airlines |
| CCT | Character Group (The) PLC | 9 | £103.90 | 34.7 | 12.1 | Toys |
| NAH | NAHL Group Ltd | 10 | £101.20 | 30.6 | 13.1 | Media Agencies |
| BKG | Berkeley Group Holdings (The) PLC | 11 | £4,720.10 | 31.6 | 12.6 | Home Construction |
| RM. | RM PLC | 13 | £135.30 | 27.3 | 14.4 | Software |
| RSW | Renishaw PLC | 15 | £1,314.20 | 31.6 | 10.9 | Electronic Equipment |
| GVC | GVC Holdings PLC | 18 | £290.80 | 25.8 | 11.7 | Gambling |
| IQE | IQE PLC | 19 | £131.40 | 19 | 20.3 | Semiconductors |
| ROR | Rotork PLC | 20 | £1,427.20 | 32.3 | 9.8 | Industrial Machinery |
| ERM | Euromoney Institutional Investor PLC | 23 | £1,296.60 | 26.8 | 10.2 | Publishing |
| DIA | Dialight PLC | 25 | £148.50 | 21.9 | 11.6 | Electrical Components & Equipment |
| FXPO | Ferrexpo PLC | 26 | £126.60 | 17 | 43.9 | Iron & Steel |
| STVG | STV Group PLC | 27 | £193.80 | 31.8 | 9.3 | Broadcasting & Entertainment |
| PAY | PayPoint PLC | 30 | £623.00 | 44.4 | 8.6 | Financial Administration |
| ECEL | Eurocell PLC | 35 | £191.00 | 28.9 | 8.8 | Building Materials & Fixtures |
As I've mentioned previously, the basic Magic Formula has had a patchy track record in recent years. It tends not to do too well during bull markets. My suspicion is that it can select bad shares due to some of its drawbacks.
So we will also run a twenty share Magic Formula portfolio based on something very close to Greenblatt's simple version and see how that performs as well.
Here's how this one looks.
Simple Magic Formula Portfolio
| TIDM | Name | Rank | MCap (m) | ROCE (ex intangibles) | EBIT yield | Subsector |
|---|---|---|---|---|---|---|
| INDV | Indivior PLC | 1 | £1,272.60 | 1187.7 | 24.6 | Pharmaceuticals |
| GTLY | Gateley (Holdings) PLC | 2 | £107.40 | 2748 | 19 | Business Support Services |
| HVO | Hvivo PLC | 3 | £168.60 | 110.7 | 48.1 | Biotechnology |
| OPHR | Ophir Energy PLC | 4 | £621.70 | 83.4 | 698.5 | Exploration & Production |
| GVC | GVC Holdings PLC | 5 | £289.50 | 656 | 11.9 | Gambling |
| CAML | Central Asia Metals PLC | 6 | £161.40 | 55.7 | 34.6 | General Mining |
| HFD | Halfords Group PLC | 7 | £627.20 | 66.3 | 12.6 | Specialty Retailers |
| HNT | Huntsworth PLC | 8 | £133.00 | 118.8 | 10.8 | Media Agencies |
| RM. | RM PLC | 9 | £138.40 | 58.2 | 16.4 | Software |
| MCLS | McColl's Retail Group Ltd | 13 | £144.50 | 49.7 | 12.3 | Food Retailers & Wholesalers |
| IQE | IQE PLC | 16 | £133.10 | 36.9 | 21.7 | Semiconductors |
| ROR | Rotork PLC | 17 | £1,440.70 | 62.5 | 9.8 | Industrial Machinery |
| UTV | UTV Media PLC | 18 | £167.80 | 75.4 | 9.1 | Broadcasting & Entertainment |
| INM | Independent News & Media PLC | 20 | €239.20 | 39.1 | 13.6 | Publishing |
| WIZZ | Wizz Air Holding PLC | 21 | £1,008.60 | 36.4 | 17.9 | Airlines |
| SFE | SafeStyle UK Ltd | 23 | £216.70 | 332.1 | 7.8 | Home Improvement Retailers |
| PAY | PayPoint PLC | 26 | £620.60 | 70.4 | 8.6 | Financial Administration |
| CCT | Character Group (The) PLC | 28 | £103.90 | 36.8 | 12.6 | Toys |
| HAS | Hays PLC | 33 | £1,975.90 | 77.9 | 7.9 | Business Training & Employment Agencies |
| ECEL | Eurocell PLC | 34 | £191.00 | 52.6 | 9.3 | Building Materials & Fixtures |
There is a reasonable amount of overlap with the lease-adjusted portfolio with thirteen shares being in both twenty share portfolios. I would expect less overlap with a larger portfolio but it will be interesting to see what difference those seven different shares might make.
Lease-adjusted EBIT yield portfolio
Wesley Gray, an American who is a bit of an expert on value investing has done a lot of research into the best valuation measures to pick winning shares. As far as he is concerned, the best measure is to compare a company's earnings before interest and tax (EBIT) - or trading profits - with the enterprise value (EV) paid for a company. This gives an earnings yield for the whole business expressed as an interest rate. The higher the interest rate, the cheaper the share.
The reason that EBIT/EV (EBIT yield) works so well is that it measures your return (EBIT) based on the total value of the business (enterprise value) taking into account equity, debt and pension fund deficits. If you just concentrate on the equity of a business (market cap) you could make mistakes and buy the wrong business or pay the wrong price. (To read about why this is the case click here).
So, we've decided to see if quality in terms of a high ROCE really matters or whether you can do better by just buying cheap shares instead. For this portfolio we've filtered the London stock exchange for shares with a market cap of £100m or more and sorted by lease-adjusted EBIT yield (highest first). Starting from the top, we've then picked the first 20 shares in different sectors.
There's also quite a bit of overlap with the lease-adjusted Magic Formula portfolio here too. This is a drawback of only having portfolios with twenty shares in them. That said, half the high EBIT yield portfolio (ten shares) is different which should mean the experiment of comparing the two approaches is still worthwhile.
This portfolio was also selected on 7th January 2016.
| TIDM | Name | Market Cap. (m) | Lease-adj EBIT yield | Subsector |
|---|---|---|---|---|
| OPHR | Ophir Energy PLC | £649.90 | 374.6 | Exploration & Production |
| FXPO | Ferrexpo PLC | £132.40 | 43.9 | Iron & Steel |
| HVO | Hvivo PLC | £174.80 | 38.7 | Biotechnology |
| CAML | Central Asia Metals PLC | £164.70 | 33.8 | General Mining |
| LAM | Lamprell PLC | £292.20 | 28.7 | Oil Equipment & Services |
| INDV | Indivior PLC | £1,340.90 | 23.4 | Pharmaceuticals |
| IQE | IQE PLC | £129.80 | 20.3 | Semiconductors |
| RMG | Royal Mail Group PLC | £4,430.00 | 17.8 | Delivery Services |
| WIZZ | Wizz Air Holding PLC | £1,022.10 | 17.6 | Airlines |
| ABBY | Abbey PLC | £254.50 | 17.2 | Home Construction |
| GTLY | Gateley (Holdings) PLC | £108.40 | 16.9 | Business Support Services |
| DRX | Drax Group PLC | £910.60 | 15.4 | Conventional Electricity |
| GDWN | Goodwin PLC | £126.20 | 14.6 | Industrial Machinery |
| RM. | RM PLC | £140.50 | 14.4 | Software |
| CAM | Camellia PLC | £259.60 | 13.8 | Farming & Fishing |
| INM | Independent News & Media PLC | €228.80 | 13.7 | Publishing |
| NAH | NAHL Group Ltd | £101.80 | 13.1 | Media Agencies |
| STCK | Stock Spirits Group PLC | £260.50 | 13.1 | Distillers & Vintners |
| RR. | Rolls-Royce Group PLC | £10,296.60 | 13.1 | Aerospace |
| GMD | GAME Digital PLC | £182.80 | 12.2 | Specialty Retailers |
Let battle commence!
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.