Formula Investing: Analyzing Popular Stock Screening Strategies

Introduction to Formula Investing

Formula investing has gained significant popularity among retail investors seeking simple yet effective strategies to outperform the market. A recent paper titled "Formula Investing" by Marcel Schwarz and Matias Hanawa provides an in-depth analysis of four well-known formula investing approaches. This article examines their findings and discusses the implications for investors.

The Four Formulas Analyzed

The researchers tested four popular investing formulas over an extensive period from 1963 to 2022 using US stock market data:

1. F-Score (Piotroski)
2. Magic Formula (Joel Greenblatt)
3. Acquirer's Multiple (Tobias Carlisle)
4. Conservative Formula (Blitz, van Vliet, and Pim van Vliet)

F-Score

The F-Score, developed by Joseph Piotroski, is an indicator of financial strength based on nine binary signals related to profitability, leverage, and operating efficiency. It aims to identify fundamentally strong value stocks.

Magic Formula

Joel Greenblatt's Magic Formula combines two factors:

1. Return on Invested Capital (ROIC)
2. Earnings Yield (EBIT/Enterprise Value)

Acquirer's Multiple

The Acquirer's Multiple, created by Tobias Carlisle, focuses on:

• EBIT/Enterprise Value

Conservative Formula

Developed by David Blitz, Pim van Vliet, and Matthias Hanauer, the Conservative Formula incorporates:

1. Low volatility
2. Momentum
3. Net payout yield (including dividends and share buybacks)

Research Methodology

The study aimed to create a unified framework for comparing these formulas over an extended period. Key aspects of the methodology include:

• Using US stock market data from 1963 to 2022
• Focusing on stocks listed on major US exchanges
• Excluding micro-cap stocks (below 20th percentile of NYSE stocks by size)
• Excluding financial stocks
• Maintaining an average of 900 stocks in the investable universe

The researchers created rankings for each formula's scores to ensure comparability across strategies. For example, the F-Score was adapted by equally weighting the nine signals and a value factor.

Key Findings

Performance Across Decile Portfolios

The study found that all four formulas demonstrated:

• Monotonically increasing returns when sorting stocks into decile portfolios
• Top decile portfolios consistently outperformed the market and bottom decile portfolios
• Statistically significant return spreads
• Alphas not explained by the Capital Asset Pricing Model (CAPM)

Factor Exposure

The researchers concluded that the outperformance was not due to any "magic" but rather efficient exposure to well-established factors:

• Momentum
• Value
• Size
• Quality

Retail Investor Perspective

The study also examined the formulas from a "do-it-yourself" retail investor viewpoint:

• Created long-only portfolios of 40 stocks
• Tested performance in the post-2000 period
• Found all formulas able to outperform the market in both raw and risk-adjusted terms

However, the researchers noted some performance decay, especially in the most recent years of the sample (last 10 years).

Implications for Investors

Validity of Formula Investing

The study largely confirms the claims made in the original books and papers introducing these formulas. Even over an extended period and with a more restricted, investable universe, the strategies demonstrated their ability to outperform the market.

Need for Continuous Innovation

Despite the overall positive results, the performance decay observed in recent years suggests that simple formulas may need ongoing refinement. As markets evolve and more investors adopt these strategies, their effectiveness may diminish over time.

Diversification Benefits

The different formulas exhibited varying behavior during different market conditions. For example, the Conservative Formula provided better downside protection due to its low volatility component. This suggests potential benefits from combining multiple formula approaches.

Factor Exposure and Risk Management

Understanding the factor exposures of each formula can help investors manage risk and potentially enhance returns. Combining formulas with complementary factor exposures may lead to more robust portfolios.

Challenges and Limitations

Recent Underperformance of Value

The study noted that value strategies, including some of these formulas, have struggled in recent years. This aligns with broader market trends favoring growth and quality factors.

Impact of Market Changes

Factors like the rise of intangible assets, changes in accounting standards, and shifts in market structure may affect the effectiveness of traditional value metrics like book-to-price ratios.

Potential Crowding Effects

As more investors adopt these strategies, their effectiveness may diminish due to crowding effects. This highlights the importance of continuous innovation and adaptation.

Future Directions for Formula Investing

International Diversification

While this study focused on US stocks, testing these formulas in international markets could provide valuable insights and potential diversification benefits.

Incorporating Alternative Data

Future enhancements to formula investing may involve integrating alternative data sources and machine learning techniques to discover new factors or improve existing ones.

Adapting to Changing Market Dynamics

As markets evolve, formula investors may need to adjust their approaches to account for changes in industry composition, the growing importance of intangible assets, and shifts in global economic patterns.

Combining with Other Factors

Integrating momentum or quality factors with value-oriented formulas may help improve performance consistency and reduce drawdowns.

Practical Considerations for Investors

Rebalancing Frequency

The study used quarterly rebalancing, which seemed to improve results compared to annual rebalancing. However, more frequent rebalancing may increase trading costs and tax implications for retail investors.

Portfolio Concentration

The research examined portfolios of 40 stocks, which may be more concentrated than some investors are comfortable with. Adjusting portfolio size based on individual risk tolerance and diversification needs is important.

Transaction Costs and Taxes

While the study's results are promising, real-world implementation would need to account for transaction costs and potential tax implications, which could impact overall returns.

Psychological Factors

Investors using formula strategies should be prepared for periods of underperformance, as seen in recent years. Having the discipline to stick with a strategy during challenging times is crucial for long-term success.

Conclusion

The "Formula Investing" paper by Schwarz and Hanawa provides valuable insights into the long-term effectiveness of popular stock screening strategies. While the results are generally encouraging for proponents of these approaches, they also highlight the need for ongoing refinement and adaptation.

Key takeaways for investors include:

1. Formula investing strategies have demonstrated the ability to outperform the market over long periods.
2. Recent performance decay suggests the need for continuous innovation and adaptation.
3. Combining multiple formulas or factors may lead to more robust portfolios.
4. Understanding factor exposures can help manage risk and potentially enhance returns.
5. International diversification and incorporation of alternative data may provide future opportunities.

As with any investment approach, it's essential for investors to thoroughly understand the strategies they employ, remain aware of their limitations, and be prepared to adapt as market conditions evolve. While formula investing can be a powerful tool for retail investors, it should be viewed as part of a broader, well-considered investment strategy rather than a guaranteed path to outperformance.

Additional Considerations

Impact of Market Capitalization

The study's findings suggest that market capitalization has played a significant role in driving returns over the past 10-15 years. This trend has favored larger companies, particularly in the technology sector, which may have contributed to the underperformance of some value-oriented strategies.

The Role of Quality

Quality factors have performed well in recent years, which may explain some of the success of formulas that incorporate profitability or financial strength metrics. Investors should consider how quality metrics interact with value metrics in their chosen formula.

Passive Flows and Market Dynamics

The increasing prevalence of passive investing and index funds may be influencing market dynamics in ways that impact formula investing strategies. Understanding these potential effects is important for adapting formulas and managing risk.

Sector and Industry Considerations

Different formulas may lead to varying sector or industry exposures. Investors should be aware of these potential biases and consider their implications for overall portfolio diversification.

Adapting to a Changing Economy

As the economy continues to evolve, with a growing emphasis on technology and intangible assets, formula investors may need to reassess traditional valuation metrics and consider new ways to identify undervalued companies.

The Importance of Patience

While recent performance of some value-oriented strategies has been challenging, historical data suggests that these approaches tend to be cyclical. Investors should be prepared for periods of underperformance and maintain a long-term perspective.

Combining Formula Investing with Fundamental Analysis

While formula investing can be a powerful screening tool, combining it with fundamental analysis of individual companies may lead to better-informed investment decisions and potentially improved results.

By considering these additional factors and remaining adaptable, investors can better position themselves to benefit from formula investing strategies while managing associated risks. As always, it's essential to align any investment approach with individual financial goals, risk tolerance, and overall portfolio strategy.

Article created from: https://www.youtube.com/watch?v=LHRz4CfywzU