Combining Value and Quality on the Swedish Equity Market: Does it hold over time?

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: The ultimate goal of many investors is to achieve alpha. Yet, most of them are unable to do this on average. Strategies achieving anomalous effects relating to e.g. size and value are often discussed in the literature and are at the core of this study. This paper specifically analyzes Joel Greenblatt's Magic Formula on the Stockholm Stock Exchange for the years between 2004 and 2018. His original approach is to assess stocks on the basis of two key metrics, Return on Invested Capital and Earnings Yield. The main rationalization behind this is to effectively source companies which are of high quality but also relatively undervalued. Moreover, this strategy has allegedly been able to realize returns well beyond the assumed risk and is therefore said to generate positive alpha. Although Greenblatt's original strategy is central to this paper, we distinguish ourselves by applying a weighting system to the two metrics. We have done this in an attempt of increasing the abnormal returns, while still not fully abandoning Greenblatt's original idea. Our results confirm that it is possible to increase the abnormal portfolio returns and we find that the alphas systematically trend upward as we increase the emphasis on Earnings Yield. In the pursuit of realizing higher alpha, we also decrypt the two metric's ability of forecasting returns. The abnormal returns are statistically significant on the 5%-level when applying the Fama-French Three-Factor and Carhart Four-Factor Models.

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