Deploying capital and opening new share positions at a time when parts of the market look seriously expensive is a prospect that will shred the nerves of many investors. While commentators are divided on how far this bull market has left to run (from a few weeks to a few years), they’re generally agreed that value opportunities are now tricky to find. That means even some of the cheapest looking shares in the market have already soared in price this year, and that can make buying them a pretty difficult thing to stomach. So is there a way of using rules-based investing to find stocks that should continue to do well even when others inevitably start crashing down?
One of the most famous investing strategies that we track at Stockopedia is Joel Greenblatt’s Magic Formula - a formula that, until some market beating performance this summer, had performed rather dismally in the UK over the past 12 months! Even so it’s a starting point in the search for good quality businesses at cheap prices that is based on sound investment thinking. While Greenblatt himself conceded that the strategy is likely to have ‘off’ years, he insisted that it’s blend of value and quality would beat the market over the long term. In increasingly frothy conditions, this Q+V (Quality + Value) combination might be worth consideration - and supercharging the strategy with some powerful new components could offer even more comfort.
How the Magic Formula works
In The Little Book That Beats the Market, Greenblatt introduced a way finding decent quality companies at cheap prices by ranking them using two simple ratios. He used the earnings yield as the measure of ‘cheapness’ and return on capital as the measure of quality (read more about that here). By rating every company on each ratio and then adding the scores together, his strategy produces a Magic Formula for each one. Of course the beauty of this relative scoring system is that there will always be a list of shares to choose from. On the downside, recent analysis has questioned whether the strategy actually overpays for quality, although other research has found that investors really should be prepared to pay extra for good quality stocks.
Greenblatt claimed some impressive returns from implementing these rules (30.8% annually in the 17 years to 2006) and with…
