Filtering: Magic Formula vs EBIT yield - which strategy will win in 2016?

One of the things that makes stock market investing so interesting is that there are lots of different ways to try and make money. There's no shortage of strategies out there backed up with lots of data telling you how good they have been in the past.

That's all well and good but what investors really want to know is are these strategies any good today? No-one really knows the answer to this question so we've decided to set up some tests.

What we are going to be doing over the coming weeks and months is to put some popular investing strategies - and some of our own - under the microscope and see how they perform in the real world of the private investor. We'll revisit them on a monthly basis to see how they have been getting on.

Using the filtering tools in ShareScope and SharePad we will select a number of different portfolios that fit the criteria of a specific strategy. The focus will be on testing a portfolio that a private investor could reasonably be expected to buy rather than following the rules of an academic study which can often be impossible for them to do.

Here's how we intend to go about this:

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The building blocks of test portfolios

  1. Each portfolio to contain 20 shares. It becomes harder and more expensive to own a lot more.
  2. £5,000 to be invested in each share to give a total investment of £100,000 - a nice number to measure future performance.
  3. Each share to come from a different sector of the stock market to reduce risk.
  4. The portfolio will be held for one year. There will be no buying and selling of shares or rebalancing of the portfolio in between.
  5. The performance of the portfolio will be measured on an offer (buying price) to bid (selling price) basis plus dividends received.
  6. Performance will be measured after taking away the costs of running the portfolio such as broker commissions (£10 per share), stamp duty (around £25 per share at 0.5%) and bid-offer spreads (the difference between the buying and the selling price of the shares).
  7. The benchmark for each portfolio is the FTSE-All Share Total Return Index.

Before we begin

The important thing to remember is that we will largely be looking at strategies based on a set of rules. There is little or no investment analysis going on here. Also, the portfolios are just experiments. Do your own research before buying any share that comes from a filter.

In many cases, there will be no profit forecasts involved. Shares will be selected on the basis of their most recent results or historic average results. This might mean that shares of companies where future profits are expected to fall might be chosen.

The strategy ultimately wins or loses based on the quality of its rules and what goes on in the general stock market as a whole.

Let's get on with the first test.

A version of Joel Greenblatt's Magic Formula.

I wrote about this strategy last month (A more thoughtful approach to Magic Formula investing) and think it is probably one of the most simple and powerful stock market strategies out there. You are supposed to beat the stock market by buying the shares of good companies at reasonable prices.

As I mentioned in my article, I have a few reservations about the basic version of Greenblatt's Magic formula. In short, I think it might be too simple as it ignores significant company liabilities such as pension fund shortfalls and hidden debts from rented assets such as buildings and equipment. (Click here to read more about hidden debts.)

This means that the simple version might lead you to think that a company is good (it has a high ROCE) when it isn't. Or you might think it is cheap (it has a high EBIT yield) when it isn't really.

SharePad allows users to rank companies using a variant of the Magic Formula which gets around these problems. It uses a lease-adjusted EBIT yield and ROCE (see the recent article for more about this).

Lease-adjusted Magic Formula portfolio

For this portfolio, we used SharePad's lease-adjusted Magic Formula column to rank the shares listed on the stock market. The Magic Formula only ranks companies with a market cap of £100m or more. Starting from the top, we have selected the first 20 shares in different sectors. This portfolio was selected on 7th January 2016.

TIDMNameRankMCap (m) Lease-adj ROCE Lease-adj EBIT yieldSubsector
HVOHvivo PLC1£168.5076.438.7Biotechnology
INDVIndivior PLC2£1,267.60375.823.4Pharmaceuticals
OPHROphir Energy PLC3£623.5037374.6Exploration & Production
CAMLCentral Asia Metals PLC4£161.4040.333.8General Mining
GTLYGateley (Holdings) PLC5£107.40106.616.9Business Support Services
WIZZWizz Air Holding PLC7£1,004.7036.217.6Airlines
CCTCharacter Group (The) PLC9£103.9034.712.1Toys
NAHNAHL Group Ltd10£101.2030.613.1Media Agencies
BKGBerkeley Group Holdings (The) PLC11£4,720.1031.612.6Home Construction
RM.RM PLC13£135.3027.314.4Software
RSWRenishaw PLC15£1,314.2031.610.9Electronic Equipment
GVCGVC Holdings PLC18£290.8025.811.7Gambling
IQEIQE PLC19£131.401920.3Semiconductors
RORRotork PLC20£1,427.2032.39.8Industrial Machinery
ERMEuromoney Institutional Investor PLC23£1,296.6026.810.2Publishing
DIADialight PLC25£148.5021.911.6Electrical Components & Equipment
FXPOFerrexpo PLC26£126.601743.9Iron & Steel
STVGSTV Group PLC27£193.8031.89.3Broadcasting & Entertainment
PAYPayPoint PLC30£623.0044.48.6Financial Administration
ECELEurocell PLC35£191.0028.98.8Building Materials & Fixtures

As I've mentioned previously, the basic Magic Formula has had a patchy track record in recent years. It tends not to do too well during bull markets. My suspicion is that it can select bad shares due to some of its drawbacks.

So we will also run a twenty share Magic Formula portfolio based on something very close to Greenblatt's simple version and see how that performs as well.

Here's how this one looks.

Simple Magic Formula Portfolio

TIDMNameRankMCap (m)ROCE (ex intangibles)EBIT yieldSubsector
INDVIndivior PLC1£1,272.601187.724.6Pharmaceuticals
GTLYGateley (Holdings) PLC2£107.40274819Business Support Services
HVOHvivo PLC3£168.60110.748.1Biotechnology
OPHROphir Energy PLC4£621.7083.4698.5Exploration & Production
GVCGVC Holdings PLC5£289.5065611.9Gambling
CAMLCentral Asia Metals PLC6£161.4055.734.6General Mining
HFDHalfords Group PLC7£627.2066.312.6Specialty Retailers
HNTHuntsworth PLC8£133.00118.810.8Media Agencies
RM.RM PLC9£138.4058.216.4Software
MCLSMcColl's Retail Group Ltd13£144.5049.712.3Food Retailers & Wholesalers
IQEIQE PLC16£133.1036.921.7Semiconductors
RORRotork PLC17£1,440.7062.59.8Industrial Machinery
UTVUTV Media PLC18£167.8075.49.1Broadcasting & Entertainment
INMIndependent News & Media PLC20€239.2039.113.6Publishing
WIZZWizz Air Holding PLC21£1,008.6036.417.9Airlines
SFESafeStyle UK Ltd23£216.70332.17.8Home Improvement Retailers
PAYPayPoint PLC26£620.6070.48.6Financial Administration
CCTCharacter Group (The) PLC28£103.9036.812.6Toys
HASHays PLC33£1,975.9077.97.9Business Training & Employment Agencies
ECELEurocell PLC34£191.0052.69.3Building Materials & Fixtures

There is a reasonable amount of overlap with the lease-adjusted portfolio with thirteen shares being in both twenty share portfolios. I would expect less overlap with a larger portfolio but it will be interesting to see what difference those seven different shares might make.

Lease-adjusted EBIT yield portfolio

Wesley Gray, an American who is a bit of an expert on value investing has done a lot of research into the best valuation measures to pick winning shares. As far as he is concerned, the best measure is to compare a company's earnings before interest and tax (EBIT) - or trading profits - with the enterprise value (EV) paid for a company. This gives an earnings yield for the whole business expressed as an interest rate. The higher the interest rate, the cheaper the share.

The reason that EBIT/EV (EBIT yield) works so well is that it measures your return (EBIT) based on the total value of the business (enterprise value) taking into account equity, debt and pension fund deficits. If you just concentrate on the equity of a business (market cap) you could make mistakes and buy the wrong business or pay the wrong price. (To read about why this is the case click here).

So, we've decided to see if quality in terms of a high ROCE really matters or whether you can do better by just buying cheap shares instead. For this portfolio we've filtered the London stock exchange for shares with a market cap of £100m or more and sorted by lease-adjusted EBIT yield (highest first). Starting from the top, we've then picked the first 20 shares in different sectors.

There's also quite a bit of overlap with the lease-adjusted Magic Formula portfolio here too. This is a drawback of only having portfolios with twenty shares in them. That said, half the high EBIT yield portfolio (ten shares) is different which should mean the experiment of comparing the two approaches is still worthwhile.

This portfolio was also selected on 7th January 2016.

TIDMNameMarket Cap. (m)Lease-adj EBIT yield Subsector
OPHROphir Energy PLC£649.90374.6Exploration & Production
FXPOFerrexpo PLC£132.4043.9Iron & Steel
HVOHvivo PLC£174.8038.7Biotechnology
CAMLCentral Asia Metals PLC£164.7033.8General Mining
LAMLamprell PLC£292.2028.7Oil Equipment & Services
INDVIndivior PLC£1,340.9023.4Pharmaceuticals
IQEIQE PLC£129.8020.3Semiconductors
RMGRoyal Mail Group PLC£4,430.0017.8Delivery Services
WIZZWizz Air Holding PLC£1,022.1017.6Airlines
ABBYAbbey PLC£254.5017.2Home Construction
GTLYGateley (Holdings) PLC£108.4016.9Business Support Services
DRXDrax Group PLC£910.6015.4Conventional Electricity
GDWNGoodwin PLC£126.2014.6Industrial Machinery
RM.RM PLC£140.5014.4Software
CAMCamellia PLC£259.6013.8Farming & Fishing
INMIndependent News & Media PLC€228.8013.7Publishing
NAHNAHL Group Ltd£101.8013.1Media Agencies
STCKStock Spirits Group PLC£260.5013.1Distillers & Vintners
RR.Rolls-Royce Group PLC£10,296.6013.1Aerospace
GMDGAME Digital PLC£182.8012.2Specialty Retailers

Let battle commence!

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.