Exactly a year ago, I published an article titled The Best Shares in Singapore’s Stock Market. The piece touched on investor Joel Greenblatt’s Magic Formula investing strategy which he shared in his book The Little Book That Beats the Market.
For the sake of convenience, I’m reproducing below what I had written about the Magic Formula in my previous article:
“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 was 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.”
In my aforementioned article, I also shared a list of 30 Singapore-listed stocks (with a market capitalisation of more than S$100 million) that carried the lowest Magic Formula scores as of 5 January 2015.The five stocks with the lowest scores were Wee Hur Holdings Ltd (SGX: E3B), Valuetronics Holdings Limited (SGX: BN2), T T J Holdings Ltd (SGX: K1Q), UE E&C Ltd, and Hock Lian Seng Holdings Limited (SGX: J2T).
I wrote back then that those 30 stocks “just might be Singapore’s best shares at the moment” and that I’d be “checking back one year later to see” how they have done. So, how has that group of 30 performed over the past year? Let’s find out from the table below:
There were some stand-out performers, like Hock Lian Seng, which had a marvelous year. But on average, our 30 Magic Formula stocks had unfortunately delivered a negative return of 14.3% after adjusting for dividends.
A period of just one year is insufficient for any strong conclusions to be made about the Magic Formula’s efficacy in Singapore’s stock market. But, there are still lessons in there. Here are my takeaways:
1) Not even the best investing strategies can work all the time
In The Little Book That Beats the Market, Greenblatt shared that back-tested portfolios constructed with the Magic Formula had suffered long stretches of underperformance and losses, though they eventually turned in solid gains on the whole.
In other words, the Magic Formula is something that works over time and not all the time. It’s really the same with most other investing approaches, regardless of how awesome their long-term performance is.
2) Investing can be an emotionally draining affair – so be prepared for that
There’s no way of knowing ahead of time whether the Magic Formula approach can truly work in Singapore. But assuming it does, its loss over the past 12 months highlight how emotionally draining investing can be. It’s not easy to sit on losses, but in investing, long-term gains often come with short-term pains.
3) Cheap stocks can hurt… at least over the short-term
The Magic Formula is a way for investors to seek value – stocks with high earnings yields are by definition, carrying low valuations. What our portfolio of 30 Magic Formula stocks show is that a low valuation is no protection against further declines, at least over the short-term. Keep this in mind the next time you go bargain hunting. Knowing what to expect when you buy stocks goes a long way in helping you invest well.
4) And lastly…
The Magic Formula is supposed to work by constructing a new portfolio each year, as mentioned earlier. In a bid to better understand how it actually will work in Singapore, I’ve come up with a new list of 30 stocks. Check them out here!
What other thoughts might you have about the Magic Formula? Do share them in the comments section below. I’d love to hear from you.
Meanwhile, if you'd like more investing analyses and important updates about the stock market, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.
Like us on Facebook to follow our latest hot articles.
The Motley Fool's purpose is to help the world invest, better.
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 and Straco Corporation.