MFI vs R3K - Still A Dead Heat

Dead Heat

If you google Magic Formula Investing, you will find that one of the most common question is "does it work"?  Having been at it since January 2006, I am well positioned to have an opinion.  My answer is that it has worked, but has not worked as promised.

In his book, Greenblatt showed tables of how the formula had worked historically on larger cap stocks and then he showed how it worked if you used it against a broader universe of stocks.  Using just the larger cap stocks (might be the equivalent of using the site at $5 billion and higher), MFI won, but only by a couple of points a year.  Using the broader universe of stocks, which I have simulated using $100 million and higher, he showed the method worked extremely well.  I seem to recall 31% a year.

Since I have tracked, it is pretty much a dead heat if you use the entire universe as seen in the table below:

	Annual		Inception to Date
Year	Russell	MFI	Russell ITD	MFI ITD
2006	11.40%	15.03%	11.40%	15.03%
2007	4.09%	-6.69%	15.96%	7.34%
2008	-37.05%	-37.97%	-27.00%	-33.42%
2009	32.51%	45.18%	-3.27%	-3.34%
2010	18.38%	22.77%	14.50%	18.67%
2011	-0.56%	-10.47%	13.87%	6.25%
2012	16.43%	9.70%	32.57%	16.56%
2013	33.01%	51.70%	76.34%	76.82%
2014	1.25%	1.28%	78.54%	79.07%

This is my "MFI Index", which takes the top 50 stocks greater than $100 million at the start of each year and holds for a year.  Since the very beginning, you'd be up 79.07%. Whilst if you had gone with the R3K you'd be up 78.54%. As I said, a dead heat. I suspect that after taxes and transaction costs, you would have been better off in R3K.

Another, broader, way to look at it is my MFI tracking portfolios. I create these every month, so there are 12x more portfolios than the MFI index listed above.  As this measure is much more automated, there is more risk of small errors (like missing a one time dividend); but I assure you I do my best.  Here is where it stands assuming you put 100,000 equally into the first 12 portfolios:

Category	Value
Total	171,002
Total Russell 3K	173,303

You can see that these are directionally the same numbers, slightly lower as 100% of the money was not is on January 1st 2006.  Here the R3K is leading.

Is It Worth The Effort?

When you look at these two tables after 7+ years, a very fair question is whether it is worth the effort? I obviously think it is, and that is why I rebooted my MFI portfolio in August of 2012.  I had stopped a year before that, in a sense I threw in the towel. It actually was commented on (MFI Diary Abandons Magic Formula Investing).

In my first run at it, I was not disciplined. I broke the rules a lot. And I let myself be sucked in by the sirens of stocks that were not as they seemed (some of the Chinese Reverse Merger stocks that made the screens).

In my re-boot, I have followed the rules 100% (except for an early sale of NUS). But more importantly, I have avoided some of the disaster-type stocks I had tended to pick before.  I am not sure if I have just been lucky so far, or have learned by passing through difficult times.  Here is a table highlighting my results thus far:

Category/Tranche	August	November	February	May	Total
Initial Investment	25,000	25,000	25,000	25,000	100,000
Current Tranche	28.2%	16.9%	10.6%	31.1%	21.9%
Previous Tranche	14.1%	43.7%	78.3%	0.0%	31.7%
MFI Overall Gain	46.2%	68.0%	97.1%	31.1%	60.6%
Current Balance	36,549	42,003	49,280	32,785	160,616
R3K Current Tranche	13.8%	42.9%	4.6%	18.2%	19.9%
R3K Overall Gain	39.0%	42.9%	26.7%	18.2%	31.7%
R3K Balance	34,747	35,734	31,670	29,542	131,693
Annualized IRR	25.4%	43.9%	75.1%	32.8%	48.1%

So, if I had put $25,000 into each of the four tranches in my re-boot, I would be at 160,616 today. Obviously that is pretty good. I would have had 131,693 in the R3K.  And if I had just bought all 50 stocks in MFI, I would be at 144,000.

Where It Has Worked

I have commented many times here that MFI has worked much, much better on stocks that pay at least a 2.6% dividend.  Unfortunately, I cannot go all the way back in my database and see by dividend yield how it has worked. I only started capturing yield at the start of 2010.  But here is a table that shows results by market cap (recall my data is the top 50 stocks greater than $100 million).

Market Cap Decile	Avg Pct Chg	Count	Min Mkt Cap
1	16.2%	492	9,222
2	11.6%	496	2,838
3	16.3%	492	1,562
4	16.2%	494	960
5	5.3%	489	758
6	6.4%	500	468
7	9.6%	489	329
8	7.0%	497	222
9	3.2%	489	148
10	4.1%	479	-
Grand Total	9.6%	4,917

Now this is a stunning, night versus day, type table.  If you walk away from reading this blog today with just a single thought, it should be this table. If you just picked stocks $960 million or greater from the $100m and greater official list, you would have averaged since January 2006 making 15% per year.  That would be (if you started with $100,000), well over $300,000. Obviously much better than the $171,000 I show above (which assumes you buy all 50 stocks).

In Conclusion

This is why I re-booted. If you stand at 20,000 feet and just look, MFI has not been worth the effort. But if you focus on the larger and more stable companies, I would call it a rousing success.  Here is what I said when I did re-boot on 8/15/12 (Jumping Back In):

I have been out of the mfi space for about a year. That has given me time to lick my wounds and re-consider my approach. Today I have decided to start afresh. Those who read my blog know I have been toying with the idea of starting again with dividend stocks as they have done well.  At the end of the day, the listings of dividend stocks is simply too restricted for me.

I had published a couple of studies last week, trying to take subsets of the mfi list to see what has done well.  The answer was that larger cap has done better (say over 700 million) and then stocks with two or three letters in their tickers have done better.

Now of course, I do not think it is the fact that the stock has three letters in ticker that makes a difference, but I think that is another signal that mfi is doing okay for the less volatile, more established names.

My plan is to buy four tranches of five stocks per tranche throughout a year.  I will not make the mistake (as I did last time) of micromanaging the tranches.  Once picked they stay picked, irregardless of what happens until the anniversary date.  I think my experience/success on my dividend portfolio has taught me not to be so antsy.