You may be familiar with Joel Greenblatt’s bestseller “The little book that beats the market”. Greenblatt’s book is a delight to read and a very good primer indeed to value investing.
In the book he makes an interesting case for a very simple investment formula that combines quality and price, and based on such a simple notion Greenblatt presents the results of his simplistic rule-driven investment framework that beats the market.
The method is very simple; he calls it the magic formula, and it beckons the question: Can rule-driven investment be taken further? Is it in fact possible to beat the formula that beats the market?
Enter https://formulastocks.com As the name implies it relies on algorithms for beating the market in a systematic fashion. This much it has in common with the magic formula. But that is just about all, though, as the mechanics are quite different.
Formula Stocks uses big data and a machine learning-based expert system for fundamental analysis, isolating winners in the markets with a high degree of accuracy.
Whereas the magic fomula holds investments for a period of one year, FormulaStocks holds investments for a longer, but variable duration, typically between one and four years.
Looking under the hood of both formulas, they share a quantitative scientific approach to investing and a businessman’s approach to purchasing stocks, but above that little else.
Let us examine the magic formula, as Mr. Greenblatt outlines his backtested investment results for the period 1988–2004.
First a few basics. The investment universe is not of unlimited size. There is a documented “small-cap effect”, where smaller capitalization companies may generate higher returns. However, since small caps are out of the reach of larger investors, we would like to make sure any comparison excludes micro cap and the lower segment of small cap companies.
The book outlines three capitalization categories, one which is of unlimited size, one which deals with companies larger than 200 million, and one with market caps larger than one billion. We will conduct this comparison at the above 200 million market cap level, because these stocks are available to most participants, while excluding the tiniest of companies. Unfortunately Greenblatt does not list the yearly returns for this category (though he does list the overall CAGR at this cap level to 23.7%). For single years we will instead have to refer to the very similar above one billion category.
There is no arguing that these results, are extraordinary.
Remember that Greenblatt presents a CAGR for > 200 million market caps of 23.7% for the same period.
Formula Stocks offers several formulas or strategies; here we will focus on the strategies named FUND and BUSINESS. I asked Thomas from Formula Stocks to run the numbers given the exact same set of circumstances as outlined in ”The little book that beats the market”, most significantly >200 million market cap as a minimum on the same US stock market, for the same time period.
Let us jump right into the results, which you can see to the left. For the FUND strategy we can observe a performance of 28.28% CAGR which exceeds the magic fomula 23.7% by 4.58 percentage points.
This does not seem like a big difference, but it becomes more significant once we consider that because FUND is a strategy structured for institutional capital it places many further demands on the investment portfolio construction than the magic formula.
It requires much larger diversification (typically 100 stocks, versus 30 in the magic fomula measurement above). Such a requirement will reduce the relative performance. In other words, if the magic fomula was also required to operate with a higher level of diversification, its results would come in at a lower level than listed in the book.
Another observation is the downside deviation versus the magic fomula. The largest one year drawdown from 1988–2004 is -0.62%, versus -25.30% for the magic formula.
A performance measure such as the Sortino ratio or the Omega function should therefore display significantly more attractive risk/ reward characteristics in the case of Formula Stocks versus the magic fomula, which we will try to ascertain shortly.
For the BUSINESS strategy one can observe dramatically better results of 44.72% CAGR compared to the 23.70% CAGR of the magic formula. This strategy was designed for professional investors, who can tolerate concentrated positions.
It is interesting that none of the years here give a negative result. The strategy manages to weather the dot-com bubble without a single losing year. This means that performance measures, which penalize downside risk, such as the Sortino ratio (yearly), come in at a level above 10, which is exceedingly rare for any investment strategy
The Sortino and Omega performance measures are chosen for comparison, because they do not have the same fatal flaw exhibited by the Sharpe ratio: They do not penalize “risk” to the upside. Few investors would consider an above-average return a “risk”, and for this reason alone the Sharpe measure should be consigned to the history books.
One of the parameters of the Formula Stocks strategies that I find most fascinating is that the best strategy examined here sports a winners-to-losers ratio of 93%, meaning that 930 investments out of 1,000 deliver a profit between the purchase and sell recommendations. This stands in stark contrast to a winners-tolosers ratio of around 60% for randomly selected stocks, and only slightly higher for the magic fomula.
“While it is impossible to predict the future, FS strategies optimize odds of prevailing against the market in any environment. This has succeeded in beating the S&P 500 in 88% of all years to date for 45 years. Since initial deployment in 2009 Formula Stocks has beaten the market by a considerable factor, and we are optimists in terms of expecting this to continue.”
— Thomas Lyck, CEO at Formula Stocks
As an interesting side note: The magic formula does not perform as well outside the timeframe chosen by Greenblatt as it does within this timeframe. Formula Stocks however perform well on every other timeframe, and if the timeframe had been chosen by Formula Stocks for comparison, FS outperformance would be significantly higher.
The strategies above beat “the little book that beats the market”, as demonstrated by the Omega risk/reward benchmark.
Visit https://formulastocks.com for more information.