There are many investment strategies available in the market that you can choose from to help you identify the right stocks to invest. But very few of these can really claim to have beaten the market consistently with credible historical evidence.
One example of such strategy is the “magic formula” investing developed by Columbia Business School professor Joel Greenblatt. This investment strategy, which aims to buy good businesses at bargain prices, ranks stocks based on two financial ratios: the earnings yield and the return on capital.
The earnings yield, which measures the operating profit of a company relative to its market size, is defined as earnings before interest and taxes (Ebit) divided by the enterprise value. The return on capital, on the other hand, which measures the earnings of a company relative to its operating assets, is defined as Ebit divided by the sum of net fixed assets and working capital.
Take note that not every stock can have similar rankings in both ratios. For example, Ayala Land may rank high at number 7 among the big cap stocks with highest return on capital, but when it comes to earnings yield, the stock falls to number 26 due to its large market capitalization. By combining the ranking of Ayala Land in the two ratios, the total score is computed at 33 points.
Ideally, for purposes of selecting the top value stocks, the lower the total score is, the higher the rank should be.
Greenblatt claims that following this strategy has proven to be effective as the stocks selected by his “magic formula” generated an annual return of 30.8 percent compared to the market’s return of 12.4 percent from 1988 to 2005.
So, if this strategy has historically worked in the United States, will this also work in the Philippine market?
Let’s say we set up a portfolio in 2013 by ranking the earnings yield and return on capital ratios of PSE (Philippine Stock Exchange) index stocks. The top 10 stocks that we would have selected are First Gen, Alliance Global, Semirara, DMCI Holdings, Robinsons Retail, ICTSI, San Miguel Corp, Aboitiz Power, Ayala Corp. and Universal Robina.
By end of 2014, we will find that the strategy would have returned by 37.2 percent as compared to the PSE index’s return of 23 percent.
If we held on to the same stocks in 2015, the portfolio would still outperform the market with a two-year total return of 19.7 percent compared to PSE index’s return of 18.1 percent.
The portfolio would continue to beat the market year in and year out in the next three years with total returns of 28 percent by 2018 as against market’s gain of 27 percent. This year, the portfolio still manages to stay ahead of the market with 40.6-percent gain from inception versus market’s return of 32.5 percent.
This sample portfolio would have gained more if we were to follow strictly the rules of the “magic formula.”
According to Greenblatt, we are supposed to rebalance the portfolio every year by selling the losers and replace them with a new set of top-ranked stocks. Greenblatt also suggested that to properly rank the right stocks, we need to exclude the financial and utility stocks and classify the selection by market value.
For example, the current top three stocks in the PSE, following the “magic formula,” with at least P100-billion market cap are Aboitiz Equity Ventures, DMCI Holdings and Robinsons Land. The top stocks in the P50-billion category are Semirara Mining, First Gen and Cosco Capital, while those under the P10-billion category are GMA Network, Ginebra and Nickel Asia.
Greenblatt recommends that the strategy be used for at least five years because he believes that good companies will pay off with good prices in the future.
Interestingly, the 10 lowest-ranked stocks in the PSE index, which initially underperformed the sample portfolio, generated total return of 40 percent by end of 2018, beating both the “magic formula” stocks and the market.
While the “magic” of this strategy may indeed help you outperform the market, it does not necessarily mean that it can deliver you the highest possible returns.
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 79th batch of RFP Program this October 2019. To register, email info@rfp.ph or text <name><email> <RFP> at 0917-9689774.