Value Investing on the Nordic Stock Market - Does the Magic Formula constitute a viable strategy for outperforming the market?

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: In this thesis we investigate if following the magic formula can yield superior investment returns in relation to the risk taken. The magic formula is a term coined by Joel Greenblatt, describing a systematic approach to successful stock investing. The strategy identifies high value companies based on return on capital that are selling at a discount to their intrinsic value based on the company’s earnings yield. In order to examine the possible relation between the magic formula and superior investment returns, we back-test the formula on the Nordic stock market between 2007 and 2016. We compare the returns of the portfolio with the benchmark OMX Nordic 40. In order to determine if the portfolio has yielded high returns in relation to each unit of risk, we apply the Capital Asset Pricing Model as well as the Fama-French three-factor model. Using the CAPM for the period 2007 to 2016 we arrive at a monthly excess return of 1.27% and an annual excess return of 17.8%. Applying the three-factor model, we yield a monthly and annual excess return of 1.29% and 14.01% respectively. Excess returns are often attributed to having taken on excess risk or merely as the result of chance. The Sharpe ratio for the period 2007 to 2016 was 0.22 for the magic formula portfolio compared to 0.027 for the OMX Nordic 40. Testing if the Sharpe ratio of the magic formula is different from the Sharpe ratio of the market, it is evident that the results are statistically significant. The years following the financial crisis of 2008 are included in the test period. It is notable that although the magic formula portfolio is significantly less diversified than the OMX Nordic 40, it performed better during the setback of 2008 and 2009, and returned to pre-crisis levels more rapidly than the market portfolio.

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