Systematic Value Investing Approaches over the Past 10 Years
Recently, Magic Formula Investing Europe (MFIE) posted a paper that back-tested several value-based mechanical investing strategies, including Magic Formula Investing (MFI), on a list of over 3,400 "Eurozone" stocks over a 10 year period ranging from 1999 to 2009. The paper itself can be downloaded here. In this article, I want to summarize some of the notable aspects and findings that may be of interest to those who follow MFI.
First, a quick summary of the project. As noted, the testing period was 10 years, and the sample universe consisted of "Eurozone" stocks. Eurozone refers to (most) countries that have adopted the euro as their legal tender, which excludes some notable European countries such as the U.K. and Switzerland (which is also not an European Union member, for that matter). The benchmark compared against was the Dow Jones Euro Stoxx 50, which consists of 50 "blue chip" Eurozone stocks such as Unilever (UN) and Nokia (NOK).
Four different mechanical, value investing techniques were used. The first was the Magic Formula technique itself, consisting of rankings by composite earnings yield and adjusted return on capital. The second was Benjamin Graham's Net Current Asset Value (NCAV) technique from his famous book The Intelligent Investor. NCAV is adequately explained in the MFIE paper. The third was MFIE's own "ERP5" ranking, which is basically a composite of Magic Formula statistics, 5-year returns on capital, and price-to-book ratio. Finally, the Piotroski method, a nine point scoring mechanism applied in this case to the top 20% of ranked Magic Formula and ERP5 stocks.
There are some nits to pick with the test itself. For one, the back-testing period is very short, just 10 years. Secondly, the test was applied to European stocks, not the U.S. market that the majority of MagicDiligence readers participate in. In reality, though, these are relatively minor issues. The past 10 years has been a fairly representative period, with two major downturns and a several year period of prosperity. And most studies have shown that the European markets behave very similarly to U.S. stocks.
So what are the relevant observations from the study data? There are 3:
1. Value-based Mechanical Investing Outperforms Blue-Chip Indexes. This is not really a surprise. All 4 value based strategies far outperformed the Stoxx index by significant margins across all market cap classes. This has been proven time and again by other studies (a good compendium is in the book What Works on Wall Street).
2. Small-Caps Provide Better Returns in these Strategies. Another point proven by numerous studies. In MFIE's paper, the smaller the market cap class, the better the returns. The best performing strategy in the "top 20 over 50 million" study generated a 16.5% annual return, while the same strategy in the "top 20 over 5 billion" test returned just 2% per year. To really get the most out of these strategies, it is imperative to include small-cap stocks.
3. One Additional Screen Really Added Value to MFI. That was ranking the MFI stocks by Piotroski score. The Piotroski score method provided the best overall returns in 9 of the 13 back-tests, and was the "worst" of the 4 in just one test. It improved the annual return of the MFI strategy by 4.9% percentage points on average - an extremely significant number. What this seems to indicate is that MFI stocks with positive business momentum are the best performers over one-year holding periods. This correlates well with James O'Shaughnessy's findings in What Works on Wall Street.