In addition to ranking stocks by the two factors in the Magic Formula, there are several criteria that Joel Greenblatt has developed to screen out companies before any ranking occurs.
From what I have gathered through The Little Book That Beats the Market, stocks from the utility and financial sectors are eliminated. This is primarily due to the unique capital structure of these industries. In addition, ADRs (foreign stocks) are also filtered out. My guess is that these stocks are filtered out because of accounting inconsistencies and the unreliability of data regarding foreign stocks in many databases.
I have also set up the screener to eliminate stocks that have less than a $50 million market capitalization. I’ve done this to come close to the 3,500 highest market capitalization stocks that Joel Greenblatt used when he backtested the Magic Formula. This last step is not a requirement, and in fact, the Magic Formula Investing site let’s you specify the minimum market capitalization of your choice.
I entered the following criteria into the Portfolio123 screener:
- Universe($ADR) != 1
- Sector != Utilit & Sector != Financ
- MktCap > 50
The final screening criteria concerning Rank just returns the stocks with a rank higher than the one I specify. I adjusted the Rank up and down to get a list of about 100 stocks, so I could compare these 100 stocks with those produced at Magic Formula Investing website.
I ran the screen and I got a list of just over a hundred stocks. I then visited the official Magic Formula Investing site, and I brought up the 100 stock list of companies over $50 million in market capitalization. I discovered that 39 out of 100 stocks on the Portfolio123 screen were on the Magic Formula Investing list. That is not a very good correlation. I was hoping to get at least a seventy percent overlap between the two lists. After the initial disappointment, I decided to try a few simple things.
First, I decided to remove the excess cash calculation out of the equations, since I was most uncertain about this calculation. I replaced my excess cash estimate (cash minus 5 percent of sales) with total cash. The results were not much better. I got 40 out of 100 stocks to match the Magic Formula list.
I also decided to try removing the cash calculation all together from the formula. This results in an equation that assumes that no company has excess cash. That resulted in only 32 of 100 stocks overlapping with the official Magic Formula Investing results.
Finally, I tried to use Joel Greenblatt’s alternative formula for people who don’t have access to a screening tool that has the data required for the Magic Formula. The alternative formula simply looks at earnings divided by price per share for earnings yield and return on assets (ROA) for the ROC quality component. That formula was real easy to set up in Portfolio123. However, this time I only got 18 out 100 stocks to match up with the official Magic Formula results.
I’m puzzled by my results. Am I missing something? I wish I had access to Joel Greenblatt to find out exactly where I am straying from his formula. I’m having a hard time believing that it could just be a difference between the two underlying fundamental datasets being used. The differences are just too great.
I’m not giving up quite yet. I’ll be trying a few more things out and sharing them here with you over the next couple of days. I’ll be looking closely at some of the top ranked stocks on the Portfolio123 screen but not on in the Magic Formula list. I also plan on backtesting my original Portfolio123 version of the Magic Formula and comparing the results with the backtest numbers published in The Little Book That Beats the Market.