A better alternative to the Magic Formula?
As you may know I was introduced to quantitative value investing by Joel Greenblatt’s excellent book called The Little Book that Beats the Market that explained his Magic Formula investing strategy.
Looking for an even better strategy
Ever since reading about Magic Formula investing described in the book I have been searching for an even better investment strategy.
And that is exactly what I found when I read the research paper written by Philip Vanstraceele and Luc Allaeys, both good friends, called Studying different Systematic Value Investing Strategies on the Eurozone stock market.
A better strategy – ERP5
In the research paper Luc and Philip set out to design and test an investment strategy that combined the following valuation and quality ratios:
- Earning Yield (EBIT / Enterprise Value) - Earning compared to the enterprise value or purchase price of the company
- Return on Invested Capital (EBIT / (Net Working Capital + Net Fixed Assets)) – The return a company generates ion the capital invested in the business.
- Price to Book (Market value / Book value) – share price compared to the book value of the company
- Trailing 5-year average Return on Invested Capital.
They named the strategy ERP5, based on the initials of the 4 factors.
All companies are ranked
To get the ERP5 rank all companies are ranked on each of the four factors. These rankings are then added together to give the ERP5 rank of the company.
All companies are then ranked from low to high by ERP5 rank with the lowest ranking companies being the most attractive investment ideas.
The ERP5 rank of more than 22,000 companies is available for you to use in the screener.
Does it work?
This is all very interesting, but does it work, you may be thinking.
Well in 2012 when a friend and I set out to find the best investment strategy in Europe over the 12 year period from June 1999 to June 2011 we tested the Magic Formula investing as well as the ERP5 strategy.
This is what we found:
Market returned only 30.5%
To put these returns into perspective, in the 12 year period the overall stock market returned only 30.54%.
The above table shows the total 12 year return of both strategies with the last column showing how much better the ERP5 strategy did compared to Magic Formula investing.
ERP5 did substantially better +200%
As you can see the ERP5 strategy, for all size companies, did substantially better than the Magic Formula investing strategy, in fact for small companies if you would have had done nearly 200% better.
But wait ERP5 can be improved
In the above mentioned back-test we also tested the ERP5 strategy with a lot of other factors and as you can see in the table below the returns of the strategy can be substantially improved.
In the table the returns you should look at are those in column Q1. They show the returns generated by first selecting the best ERP5 companies and then sorting them by the items in the Secondary Factor column.
732% over 12 years
This means you could have earned the highest return of 732.1% over 12 years if you invested in the best ranked ERP5 companies that also had the highest 6 month price index (6 month price increase).
As you can see the ERP5 investment strategy is something that deserves your attention because as a stand-alone strategy it has performed substantially better, not only than the market, but also better than the Magic Formula investing strategy.
Not only that but you can also see that if you combine the ERP5 strategy with other factors, such as 6 or 12 months price momentum you can substantially increase your investment returns.
Wishing you profitable investing
PS To find Magic Formula investment ideas in the countries you invest in (for less than an inexpensive lunch for two) click here: Join today
These Magic Formula articles may also interest you:
Does the Magic Formula also work in Finland?
Does the Magic Formula also work in Belgium, Luxembourg and the Netherlands?
A better alternative to the Magic Formula?
Investment strategy tested: Magic Formula investing & 6 month Price Index
How to get the best returns with Magic Formula investing
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