U.S.-based investor Joel Greenblatt may not be a household name for most stock market participants, but he really should be. According to the New York Times, “Mr. Greenblatt said he gained 50 percent a year before fees from 1985 to 1994, just before he returned all outside investors’ capital.”
After that, Greenblatt did not stop investing. According to a 2014 book titled Excess Returns, Greenblatt likely generated annualised compounded returns of around 45% for 19 years in total. For those counting, that turns every $1,000 entrusted to him into more than $1.1 million.
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That’s a phenomenal track record. In 2005, Greenblatt published a best-selling investment book called The Little Book That Beats the Market. In it, he wrote about a nifty little “Magic Formula” for the stock market which he did some rigorous back-testing on and found it to have beaten the market by a wide margin over a 17 year period.
All that magic
The formula works by first ranking all shares (excluding financials and utilities because of their unique financial structure) on their returns on invested capital. Each share is given a score based on their rank. Then, all shares (again excluding financials and utilities) are ranked on their earnings yield and given a score based on that. Both scores are then added up.
A portfolio of the lowest-scored shares would be held for a year before the ranking exercise is done again and a new portfolio is constructed based on the shares with the lowest scores at the time the latest ranking exercise is done. This would go on every year. Rinse and repeat.
Greenblatt’s idea behind the Magic Formula is deceptively simple but it works on solid investment footing – he wants to buy the best quality shares (the ones with the highest return on invested capital) at the lowest possible price (the ones with the highest earnings yield). That’s a strong recipe for success.
By constructing a 30-stock portfolio of the shares with the lowest scores and back-testing the results from 1988 to 2004, Greenblatt showed that his Magic Formula approach generated annualised returns of 30.8% compared to the S&P 500’s 12.4% annual gain. The S&P 500 is a broad market index in the U.S. which is akin to the Straits Times Index (SGX: ^STI) here in Singapore.
Not knowing where it’d work
Today, Greenblatt’s showing his conviction in the Magic Formula by managing funds with assets of more than US$5 billion based on slight modifications of what he wrote about in his best-selling book.
But despite his success thus far, it’s not a guarantee that a Magic Formula approach may work in Singapore. There may be structural differences between the stock market here and in the U.S. which might reduce the efficacy of such an approach by a large degree.
For instance, there may be liquidity issues given the much smaller size of Singapore’s stock market. Also, the quality of the companies may differ – a local share that’s ranked highly for its quality here may not even be as good as a run-of-the-mill firm in the U.S. Then, there’s also the number of quality and cheap shares to fret about. It may not be difficult to find 30 shares with both attributes in the U.S. but that’s because investors have thousands of companies to choose from – in Singapore, where there are less than 800 listed companies, it may be slim pickings for investors.
An experimental test
Yet, it’s no real harm to take a look at what the Magic Formula might achieve in Singapore’s market. To do that, I’ve made a screen of local shares (with market capitalisations of more than S$100 million to account for liquidity issues) based upon Greenblatt’s Magic Formula. Here are the five shares with the lowest scores: Wee Hur Holdings Ltd (SGX: E3B), Valuetronics Holdings Limited (SGX: BN2), T T J Holdings Ltd (SGX: K1Q), UE E&C Ltd (SGX: NI3), and Hock Lian Seng Holdings Limited (SGX: J2T)
The complete list of the top 30 shares are shown in the table below.
Source: S&P Capital IQ (data as of 5 January
It’s anyone’s guess as to how this might all work out. But, I’d be checking back one year later to see the performance of this portfolio of 30 stocks. For all we know, these just might be Singapore’s best shares at the moment.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Kingsmen Creatives.