With the recent trend of stocks with negative earnings outperforming the broader market, a timely analysis has emerged regarding the effectiveness of various investment formulas developed to identify high-performing stocks. Researchers Marcel Schwartz and Matthias X. Hanauer delved deep into the performance of four widely recognized stock-selection methods: the F-Score, Magic Formula, Acquirer’s Multiple, and Conservative Formula.
The F-Score, created by Joseph Piotroski, combines nine criteria to assess a company’s financial health in three primary areas: profitability, leverage, and operating efficiency. This score is then integrated with a valuation metric, the book-to-market ratio, to rank stocks based on their attractiveness for investment.
Joel Greenblatt’s Magic Formula, which gained traction through his book, utilizes a blend of two metrics: earnings yield and return on capital. Earnings yield serves as a relative valuation gauge, while return on capital reflects a company’s profitability and efficiency.
Tobias Carlisle’s Acquirer’s Multiple stands out by relying on a single valuation metric—calculating a company’s enterprise value divided by its operating earnings. This formula simplifies the investment selection process by focusing on a straightforward measure of value.
The Conservative Formula, co-authored by Pim van Vliet and David Blitz, merges three common stock anomalies to produce a stock rank. The components include volatility, net payout yield, and price momentum, giving this formula a balanced approach to investment.
The study examined the U.S. stock market, specifically excluding microcap companies, over a period stretching from 1963 to 2022. By categorizing stocks into quintiles based on their respective investment formula rankings, the analysis found that all four approaches yielded increasing returns, with the top-ranked decile significantly outperforming the bottom tier and the overall market.
When expanding the analysis to the top 40 stocks from each formula between 2000 and 2022, results revealed that three of the four formulas achieved substantial annualized outperformance compared to the market index. However, this outperformance came with higher volatility and larger maximum drawdowns than the overall market. The Conservative Formula, despite being slightly lower in annualized returns, provided a smoother investment experience thanks to its focus on lower volatility.
The underlying trends in the successful investment strategies showcased valuation and profitability as primary factors driving returns. Notably, price momentum was incorporated as a secondary driver, underscoring its historical performance benefits for investment techniques.
Despite the impressive results of these investment formulas, the analysis emphasizes a key challenge: the emotional toll of maintaining a disciplined approach during periods of underperformance. Investors utilizing these strategies would need to endure significant fluctuations in returns. For instance, the Acquirer’s Multiple demonstrated a pronounced tracking error, indicating that investors could witness dramatic outperformances or underperformances over time.
The challenge of adhering to these strategies is particularly evident in the current market landscape, where stocks with negative earnings have surged ahead. This reflects a broader deviation from the traditional principles of valuing quality and profitability, raising doubts among investors relying on strategies focused on financially sound companies.
As the analysis encapsulates, while the fundamental principles of stock selection remain pertinent, navigating the emotional complexities of investing presents a significant hurdle. As the market continues to evolve, investors may find the path to executing these formulas increasingly complex, highlighting the age-old adage of renown investor Warren Buffett: “Investing is simple, but not easy.”
