Value investing has had a rough ride over the past 10 years. The part-art, part-science discipline of buying stocks that are cheap relative to what they earn or what they own is a well-worn strategy, but it’s also a painful one when it’s out of favour.
Over many decades, research shows undeniable outperformance from value strategies over time. But between periods of market-beating returns, value has spells in the wilderness. It’s these moments of agony that mean many value investors - professionals included - struggle to stick with their strategies. And this is what we’ve seen over the past decade.
Back in 2005, an American investor called Joel Greenblatt came up with a new kind of value strategy that still resonates with investors today. In The Little Book That Beats the Market, he set out an approach that blends value with quality and ranks the entire market for how relatively ‘good and cheap’ each stock is.
With this approach, Greenblatt said investors could easily find companies that might be genuinely underpriced. Sure, the list would often contain broken and unloved shares. And given that this was still a value strategy, there would certainly be disappointments. But his so-called ‘Magic Formula’ would offer a higher probability of success.
A model of the Magic Formula strategy applied to the UK market shows just how good - but also how variable - the results can be. Between 2017 and 2019 it delivered reasonable returns, but like many other strategies, the market crash of 2020 hit it hard. Since then, we’ve seen a steady recovery in the performance of Magic Formula stocks - especially since last autumn. Tracking of quarterly re-balanced portfolio of Magic Formula stocks has seen it deliver an 82.8% return (pre-costs) over the past year.
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How the Magic Formula works
Greenblatt’s strategy uses two simple ratios: the earnings yield as a measure of ‘cheapness’ and return on capital as a measure of ‘quality’.
Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value).…
