ERP5 & Price Index 6m
A strategy to beat the Magic Formula
This investment strategy was developed by two friends, Philip Vanstraceele and Luc Allaeys when they set out to develop a strategy that outperforms the Magic Formula as described in the excellent book by Joel Greenblatt called The Little Book that Beats the Market.
How is it calculated?
The strategy finds undervalued companies based on the following four ratios:
- Earnings Yield
- Return on invested capital (ROIC)
- Price to Book and
- 5 year average ROIC.
They named the strategy ERP5, based on the initials of the 4 factors.
To get the ERP5 ranking or value all companies are ranked on each of the four factors. These rankings are then added together to give the ERP5 value of the company.
Companies with the lowest ERP5 value or rank are the most attractive investment ideas.
What returns does it generate?
We tested ERP5 as an investment strategy in Europe over the 12 year period from June 1999 to June 2011.
Source:Quantitative Value Investing in Europe: What works for achieving alpha
As you can see companies with the lowest ERP5 values (the most undervalued companies), quintile 1 (Q1) in the above table, did a lot better than companies with a high ERP5 value, and did this for small, medium and large companies.
Substantially better than the market
Low value ERP5 companies all substantially outperformed the market which returned 30.54% over the same 12 year period.
Before I show you by how much it beats the Magic Formula first some information on how we tested.
We only use historical accounting data and no forecasts. The reason
being is that there is ample evidence that forecasts cannot be relied
on. For example, in his excellent book, ‘The New Contrarian Investment
Strategy’, David Dreman mentioned a study that used a sample of 67.375
analysts' quarterly estimates for companies listed on US stock
The study found that the average analysts’ error was 40%, and that
the estimates were misleading two-third of the time! A less important
but not insignificant factor is that historical accounting data is also
The backtest universe and benchmark
Our backtest universe is a subset of companies in the Datastream
database containing an average of about 1500 companies in the 17 country
Eurozone market during our 12-year test period (13 June 1999 to 13 June
We excluded banks, insurance companies, investment funds, certain holdings companies, and REITS.
We included bankrupt companies to avoid any survivor bias. Bankrupt
companies, or companies that were taken over, returns were calculated
using the last stock market price available before the company was
We excluded companies with an average 30-day trading volume of less than €10 000.
It was not a good time to invest in stocks
The test period was most certainly not a good time to be invested in stocks.
The 12-year period we tested included a stock market bubble (1999), two
recessions (2001, 2008-2009) and two bear markets (2001-2003,
In spite of all the substantial movements, over the whole period it
was essentially a sideways market, as Vitaliy Katsenelson defined in his
book, ‘The Little Book of Sideways Markets’.
Holding periods and quintile tests
Each year all the portfolios we tested were formed on 16 June. We
chose 16 June as most European companies have a December year-end and by
this date all their previous year-end results would be available in the
The annual returns for our back test portfolios were calculated as
the 12-month price change plus dividends received over the period.
Returns were compounded on an annual basis.
This means each year the return of the portfolio (dividends included)
would be reinvested (equally weighted) in the strategy the following
The portfolios were all constructed on an equal-weighted basis.
In order to test the effectiveness of a strategy, we divided our back
test universe into five equal groups (quintiles), according to the
factor we were testing. For example, when testing a low price-to-book
(PB) value strategy, we ranked our back test universe from the cheapest
(lowest PB) to the most expensive (highest PB) stocks.
The cheapest 20% of companies were put in the first quintile (Q1),
the next in the second, and so on, with the 20 % of companies with the
highest price-to-book value in the fifth quintile (Q5).
Does it beat the Magic Formula?
For the same 12 year period mentioned above we also tested the Magic Formula (applied to European companies) and this is what we found:
The table shows the total 12 year return of both strategies with the last column showing how much better the ERP5 strategy did compared to the Magic Formula.
ERP5 did substantially better +200%
As you can see the ERP5 strategy, for all size companies, did substantially better than the Magic Formula, in fact for small companies if you would have had done nearly 200% better.
You can also improve the returns of the ERP5 strategy
We also tested the ERP5 strategy with a lot of other ratios and as you can see in the table below the returns of the strategy can be improved substantially.
Source: Quantitative Value Investing in Europe: What works for achieving alpha
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 (most undervalued) and then sorting them by the items in the Secondary Factor column.
Best combination +732% was Momentum
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 (price momentum).
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.
Not only that but if you combine the ERP5 strategy with other factors, such as 6 or 12 months price momentum you can substantially increase your returns.
Please note: This website is not associated with Joel Greenblatt and MagicFormulaInvesting.com in %any way. Neither Mr Greenblatt nor MagicFormulaInvesting.com has endorsed this website's investment advice, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website.
May 1999 - May 2011
+19.3% pa +732.1% 12yr