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Back Testing “The Magic Formula” in the Nordic Region

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Back Testing “The Magic Formula” in the Nordic Region STOCKHOLM SCHOOL OF ECONOMICS DEPARTMENT OF FINANCE MASTER THESIS 2009 Back testing “The Magic Formula” in the Nordic region Victor Persson† & Niklas Selander†† ABSTRACT We will in this thesis back test Joel Greenblatt’s magic formula on stocks in the Nordic Region between January 1st 1998 and January 1st 2008. We will compare the return with benchmarks such as MSCI Nordic and S&P 500 as well as the return predicted by the Capital Assets Pricing Model (CAPM) and Fama French’s three factor model. The portfolio based on the formula had during the ten year period a compounded annual growth rate (CAGR) of 14.68 percent compared to 9.28 percent for the MSCI Nordic and 4.23 percent for the S&P 500. However, the intercept was not significant neither when testing against the CAPM or Fama French’s three factor model on the 5 percent level. Adding transaction cost lowers the CAGR to 11.98 percent. With transaction costs, the intercepts were not significant neither when testing against the CAPM or Fama French’s three factor model on the 5 percent level. The Sharpe ratio for the portfolio was above MSCI Nordic and S&P 500 both with and without transaction costs. We also find that the return of the portfolios improve when including intangible assets in the magic formula. † [email protected] †† [email protected] TUTOR: Clas Bergström KEYWORDS: Efficient markets, Magic Formula, Joel Greenblatt ACKNOWLEDGEMENTS: We would first like to thank Professor Clas Bergström for his advices and guidance. We would also like to thank Pauline Nisha and Wilfred Wilson from Thomson regarding their invaluable help regarding the DataStream database. Table of Contents 1 INTRODUCTION ..........................................................................................................................1 2 PREVIOUS RESEARCH ..................................................................................................................2 2.1 EFFICIENT MARKET HYPOTHESIS........................................................................................................... 2 2.2 FINDINGS CONTRADICTING THE EMH .................................................................................................... 3 2.2.1 Size effect .............................................................................................................................. 3 2.2.2 January effect ........................................................................................................................ 3 2.2.3 Weekend effect ..................................................................................................................... 4 2.2.4 Contrarian ............................................................................................................................. 5 2.2.5 Momentum ........................................................................................................................... 5 2.2.6 Ratios .................................................................................................................................... 6 3 GREENBLATT’S MAGIC FORMULA ................................................................................................7 3.1 INTRODUCTION ................................................................................................................................. 7 3.2 THE MAGIC FORMULA ........................................................................................................................ 7 3.2.1 Ranking ................................................................................................................................. 8 3.2.2 Results ................................................................................................................................... 9 3.2.3 Risk and investment time horizon ....................................................................................... 10 3.3 GREENBLATT VERSUS EFFICIENT MARKET HYPOTHESIS ............................................................................ 11 3.4 PREVIOUS BACK TESTING OF THE GREENBLATT’S WORK ......................................................................... 12 3.5 THE POSSIBILITY TO USE ANOMALIES AS TRADING STRATEGIES .................................................................. 15 3.6 THE ANOMALIES AND GREENBLATT ..................................................................................................... 16 4 METHOD AND DATA ................................................................................................................. 16 4.1 METHOD ........................................................................................................................................ 16 4.2 BAD MODEL PROBLEM AND THE JOINT HYPOTHESIS PROBLEM ................................................................. 20 4.3 DATA ............................................................................................................................................. 21 5 HYPOTHESIS ............................................................................................................................. 21 6 RESULTS ................................................................................................................................... 23 6.1 HYPOTHESIS 1 ................................................................................................................................. 23 6.2 HYPOTHESIS 2 ................................................................................................................................. 24 6.3 HYPOTHESIS 3 ................................................................................................................................. 25 6.4 HYPOTHESIS 4 ................................................................................................................................. 26 6.5 ADDING TRANSACTION COSTS ............................................................................................................ 27 6.6 ROLLING 12 MONTH PERFORMANCES ................................................................................................ 30 7 DISCUSSIONS AND CONCLUSIONS ............................................................................................. 30 i 8 FURTHER RESEARCH ................................................................................................................. 31 9 REFERENCE LIST ........................................................................................................................ 32 9.1 ACADEMIC REFERENCES .................................................................................................................... 32 9.2 NON-ACADEMIC REFERENCES ............................................................................................................ 34 9.3 OTHER SOURCES .............................................................................................................................. 34 9.4 DATABASES .................................................................................................................................... 34 10 APPENDIX ............................................................................................................................. 35 10.1 MORE OF GREENBLATT’S RESULTS ...................................................................................................... 35 10.2 ROLLING 12 MONTH PERFORMANCE .................................................................................................. 36 10.3 THE CASE OF RAYSEARCH LABORATORIES ............................................................................................ 37 10.4 ORIGINAL LIST OF STOCK................................................................................................................... 41 10.5 THE STOCKS SELECTED IN EACH PERIOD .............................................................................................. 55 10.6 RESULT IN EACH PERIOD ................................................................................................................... 61 10.7 SUMMARY OUTPUT OF REGRESSIONS .................................................................................................. 62 ii 1 Introduction Can you beat the market? Or rather, can you systematically beat the stock market taking advantage of market inefficiency? This is a frequently debated question within academic circles as well as among practitioners in the investment community. Supporters of the Efficient market hypothesis (EMH) claim that you cannot, while others argue that you can. Investors systematically outperforming the market have been present during many decades, including; John Templeton, Warren Buffet and Peter Lynch. We will in this thesis examine a trading strategy from the perspective of EMH. The trading strategy that we have chosen is the strategy presented by hedge fund manager and adjunct professor Joel Greenblatt in his bestselling book The little book that beats the market. Since the efficient market hypothesis became widely accepted in the academic world in the 1970s (Schiller (2003)), many attempts have been done to show its flaws. We will highlight some of the anomalies that have been found, and to large extent disappeared, during the years. Some of the anomalies are more interesting in the understanding of our study, explaining the reason for us to penetrate deeper into those1. We will summarize these anomalies and give our current view on their implications on investment strategies
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