One of the most popular mechanical investing strategies is outlined in Joel Greenblatt's best-seller "The Little Book That Beats the Market". Beyond the credibility that comes from someone whose private investment partnership, Gotham Capital, has produced 40 per cent a year returns over the past 20 years, Mr Greenblatt outlines a "magic formula", based on how he invests, that anyone can use.
The formula has only two inputs, a company's P/E and its return on capital (ROC). The rationale is straightforward: buy shares in good businesses, measured by ROC, only when they're available at bargain prices, measured by low PE. It is essentially a "Growth at a reasonable price" or GARP strategy. The magic formula first sorts all shares by PE, from low to high to get to a shares PE rank. It then sorts the share universe by ROC to get a ROC rank. Each share is then provided a Magic Formula (MF) score by adding the PE and ROC ranks together. The 20-30 shares with the lowest MF scores form the basis of your portfolio. You repeat the excersise and rebalance your portfolio annually.
Using this approach to create a regularly updated portfolio of about 20 stocks with the lowest combined MF rankings, Mr Greenblatt tested his formula between 1988 and 2004. The results were remarkable: with only one down year, the magic portfolio would have returned 30.8 per cent a year, against a 12.4 percent annual return for the S&P 500. There is a warning though - the Magic Formula must be given time to work and can be volatile.
Joel runs a website specifically for his strategy at http://www.magicformulainvesting.com but it is unfortunately only of use for US citizens. If you would like to form your own MF Portfolio, go look at the MF Blog where we regularly publish stocks that pass the screens on a monthly basis.
At PowerStocks we provide screens and track the performance of a variety of Magic Formula portfolios. There is the 5-share T40-5SH-MFx series which we have been tracking since November 2008. It runs the screen on the JSE TOP40 shares only as we have seen this to be very successful on the JSE. Each quarter we create a new model portfolio to track in real time for forward-testing purposes and to use in later research. They are dubbed T40-5SH-MF1 (Nov 2008), T40-5SH-MF2 (March 2009) and T40-5SH-MF3 (June 2009).
We also track a 10 share variant screened against the entire JSE (ALL-STOCKS) that resembles Mr Greenblatts method the closest. Again we create a model portfolio each quarter dubbed MF-10SH-NOV08 and MF-10SH-MAR09 and MF-10SH-JUN09.
We also created a special investment strategy dubbed PowerShares that is based on applying the Magic Formula to a specially selected JSE TOP100 universe. Backtests for this startegy are well documented in our backtest research section.
To see how well the Magic Formula investment strategy worked on the JSE since 1999, click on the BACKTEST link at the top of this page. To see how the Magic Formula method stacks up against other famous strategies, go to the SCOREBOARD menu item at the top of the page.
To see a rare and interesting CNBC interview with Greenblat, have a look at the below video clip.