How to apply Joel Greenblatt’s magic formula to HK equities

April 13, 2017 16:45
Joel Greenblatt’s so-called magic formula for stock picking tries to select companies that score highest in terms of earnings yield and return on equity. Photo: Bloomberg

Although the Hang Seng Index posted a 9.6 percent gain in the first quarter, only 600 out of the 2,000 or so stocks outperformed the benchmark, or about 30 percent of the total number of listed counters.

Meanwhile, nearly 40 percent of stocks posted losses. That clearly shows picking the right stocks is the key to winning the game.

Fund manager Joel Greenblatt describes in his best selling book The Little Book That Beats The Market how he managed to achieve an annualized return of 23.8 percent by using his so-called “magic formula” to build a stock portfolio.

The formula basically covers two key variables — earnings yield and return on equity.

If one stock is undervalued, the earnings yield would be relatively high. That would offer relatively higher potential returns for investors when they buy the stock at that time.

Return on capital is a gauge to evaluate the management’s capability to generate profit from a company’s assets.

Therefore, the core of the magic formula is to identify good companies available at low prices.

Let’s use Joel Greenblatt’s magic formula to pick value stocks in Hong Kong to test their performance over past decade to see if it works.

We built three different portfolios with 10 stocks each using the magic formula and compare the performance with the Tracker Fund in the back test.

All three portfolios go through rebalancing every six months. The first one does not have a stop loss mechanism, while the third one has set requirement for selecting stocks with a minimum trading volume.

The back tests show that the three portfolios have posted a total return of 1,604.2 percent, 1,465.2 percent and 290.7 percent over the past decade.

That exceeds the return of 46.5 percent in the Tracker Fund in the same period. Therefore, if we invested HK$500,000 in the three portfolios, it would have turned into HK$8.52 million, HK$7.83 million and HK$1.95 million, respectively.

The first portfolio has the highest floating loss on average over the past 10 years, since it has no stop loss mechanism. And the second portfolio has the lowest floating loss over the period. On a risk-adjusted basis, the second portfolio appears to be the best.

We built the third portfolio since the first two portfolios have some stocks with very little trading.

However, the annual return of the third portfolio is considerably lower than the other two, suggesting that a significant portion of return in the magic formula-based portfolio comes from certain small-cap stocks.

This article appeared in the Hong Kong Economic Journal on April 12

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist