Back Testing Magic Formula on Indian Stock Markets : An Analysis of Magic Formula Strategy

The research tried to simulate functioning and evaluate results of a value investing strategy known as Magic formula developed by Joel Greenblatt. This strategy involves ranking a set of companies based on their Return on Capital Employed (ROCE) and Price-Earning (P/E) ratio, then adding these ranks to obtain a combined score and then choosing 30 companies with least joint score to form an equally weighted portfolio. In this research we show the working of this strategy for a period of 8 years starting from 1st July, 2012 till 1st February, 2020. Through this research we have tried to find answers to two important questions. First, whether the returns of this strategy outperforms the returns generated by broad market indices. In this research the broad market index taken into consideration for comparison is BSE Sensex. Second, whether the returns of this strategy improves on increasing/decreasing the number of companies to be included in the portfolio. To check this we have formed 10-stock and 50-stock portfolios and compared their returns and other variables with the primary 30-stock portfolio. For finding the answers to above questions, this strategy was used on the dataset of BSE 500 companies excluding financial companies and companies with negative earnings. The results obtained from the application of the Magic Formula have provided the following answers to the above mentioned questions. First, the risk-unadjusted returns generated exceeded market returns in 5 out of 8 years. CAGR of BSE Sensex is 9.31% against 13.89% of 30-stock Magic Formula portfolio. Thus the Magic Formula outperformed the market significantly. Second, CAGR of 30-stock portfolio exceeded CAGR of both of 10- stock and 50-stock portfolios and thus it is evident that 30-stock Magic Formula portfolio provides the best possible returns. Thus, the results of this research bolsters the application of value investing strategy professed by Joel Greenblatt named as “The Magic Formula” in the Indian Markets. It not only reaffirms the use of Magic Formula ideology but also the adoption of elements such as the number of companies to be included in the portfolio