Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors

CHAPTER 11

Problems with the Magic Formula

“The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.”

—Anonymous1

We know that the Magic Formula comprises two equally weighted components: return on capital (ROC), a measure of quality; and the earnings before interest and taxes (EBIT) version of the enterprise multiple, a price ratio. After conducting an exhaustive back-test of different price ratios in Chapters 7 and 8, we saw that the EBIT enterprise multiple performed the best. Against formidable opposition in the form of other widely used individual price ratios, long-term average “normalized” price ratios promoted by Graham, and composite price ratios suggested by O'Shaughnessy, the humble EBIT enterprise multiple stood out. Greenblatt's selection of it as the price metric for the Magic Formula seems serendipitous. But what of the quality metric, ROC?

The stand-alone performance of the EBIT enterprise multiple is so strong that we wondered how much it actually contributed to the overall performance of the Magic Formula. We decided to test it by separating the Magic Formula into its constituent parts, and comparing the performance of the constituents to the performance ...