My Joel Greenblatt Magic Formula screen has endured a second tough year in a row, which has prompted me to conduct a bit of an experiment with the five years' worth of performance data that I've collected from the screen. What I've looked into is whether the use of a stop-loss would have made the screen perform better over the period.
There are reasons to think the Magic Formula screen should make a good fit with a stop-loss strategy. For one thing, the screen focuses on a decent number of shares each year - 30 - which gives a reasonably diverse starting point for my back-testing. What's more, the screen is very simple in its approach and can therefore be expected to pick its fair share of losers even when it performs well overall. That's especially true because of its focus on 'cheap' shares, which can often prove to be cheap for a reason.
The reason stop-losses are popular is that they make investors take the pain of a loss early rather than hanging on to a losing position in the false hope that things will get better. However, sometimes things do get better even after big share price falls, and if this happens an activated stop-loss is akin to being panicked out of a position before it has had time to come good.
The 2012 performance of the screen provides a good illustration of the argument against stop-losses. Shares in set-top box maker Pace, for example, recorded a 153 per cent gain over a 12-month period despite being down by 27 per cent at one point. I have also included details of all the 2012 Magic Formula shares performance, comparing a 15 per cent trailing stop-loss with a simple buy-and-hold strategy. The tables are ordered from the shares that would have benefited the most from having a stop-loss in place to those where it would have been most costly (ie would have led to missing out on big gains).
I've tested a range of trailing stop-losses on the Magic Formula screen. A trailing stop-loss is triggered when a share price falls by a given percentage below its highest price since it was 'bought'. In my test, the loss taken when a stop-loss is activated is based on the closing price on the day the stop-loss was triggered. This is done to try to account for the fact that shares often lurch down through stop-loss levels meaning the price at which they are sold is below the limit that has been set. Once a stop-loss is activated, the 'money' is left on the sidelines and not reinvested until a new Magic Formula portfolio is selected. There is also no account taken for dealing costs in this back-test.
While I usually track the performance of screens based on total returns (share price movements plus dividends reinvested), the stop-loss tests only look at capital returns. The table below shows how various levels of trailing stop-losses affected the performance of the Magic Formula screen.
| 2011 | 2012 | 2013 | 2014 | 2015 | Cumulative Capital Return | Years of outperformance | |
|---|---|---|---|---|---|---|---|
| 5% stop-loss | 1.2% | 5.1% | 1.7% | 4.5% | 1.2% | 14% | 2 |
| 10% stop-loss | 0.0% | 5.9% | 3.4% | 3.9% | 2.1% | 16% | 2 |
| 15% stop-loss | 2.8% | 6.2% | 13.7% | 5.2% | 4.6% | 37% | 3 |
| 20% stop-loss | 3.5% | 10.6% | 19.3% | 5.3% | -0.1% | 44% | 4 |
| 25% stop-loss | 5.1% | 9.9% | 21.3% | 3.4% | -2.9% | 41% | 4 |
| 30% stop-loss | 5.0% | 17.7% | 21.1% | 1.9% | -5.2% | 45% | 4 |
| No stop-loss | 8.8% | 20.1% | 23.2% | -3.3% | -16.3% | 30% | 3 |
| FTSE All-Share | -0.9% | 8.4% | 5.3% | 6.3% | -16.2% | 0.8% | - |
Source: Thomson Datastream
A key trend, and an unsurprising one, is that stop-losses would have been at their most useful for the Magic Formula screen during the more challenging performance periods of the past two years. However, the damage done to the strong performance generated in the first three years of the screen more than offset the recent downside protection in the case of a 5 per cent and 10 per cent stop-loss. It's also interesting to note that it was the widest stop-loss I tested - a whopping 30 per cent - that proved most effective at boosting the screen's returns. This somewhat flies in the face of the conventional wisdom that investors should look to take many small-losses while pursuing a few big winners. That said, my little experiment with the Greenblatt screen is based on a fairly limited amount of data. So while I feel it is of interest for observing stop-losses in action, firm conclusions can't credibly be taken from it. Indeed, the use of stop-losses by investors is best seen as very much a matter of personal preference.
As already mentioned, last year's screen had a tough time. That said, it did at least outperform a very poor market on a total return basis. Over the year it delivered a negative total return of 11.6 per cent, or 7.3 per cent for the top 10 stocks. While this is a big loss, it is actually better than the FTSE All-Share, which was 12.2 per cent in the red over the period. Ironically, the star performer from last year's picks was Quindell, the company from last year's stock selection that looked the biggest rogue among the 30. Since being picked by the screen, the company has been renamed Watchstone Group and has returned 90p to shareholders and gone through a 10-for-one share consolidation.
The screen's cumulative total return over the past five years now stands at 59 per cent, or 94 per cent based on the top 10 ranking shares from each screen. That compares with 22 per cent from the FTSE All-Share - comparisons between the total return figures and capital returns show what a massive impact dividends and their reinvestment would have had over five years.
Greenblatt vs FTSE All-Share
| Greenblatt top 10 | Greenblatt top 15 | Greenblatt top 20 | Greenblatt | FTSE All-Share | |
|---|---|---|---|---|---|
| 16 Feb 2015 -12 Feb 2016 | -7.3% | -11.3% | -12.4% | -11.6% | -12.2% |
| 5 Year | 93.7% | 82.2% | 81.0% | 59.0% | 21.5% |
Source: Thomson Datastream
The Magic Formula screen, which is based on the method explained in hedge fund great Joel Greenblatt's The Little Book That Beats The Market, is very simple. Shares are ranked based on both an earnings yield (similar to a price/earnings ratio but expressing earnings before interest and tax as a percentage of enterprise value) and return on tangible assets. The 30 shares showing the best combined rankings are then selected and held for a year. Mr Greenblatt had a very natty formulation of these ratios to take account of only productive assets as well as factoring in debt to his earnings yield calculation by using enterprise value (market cap plus net debt) rather than just market cap on its own. The 30 top ranking shares out of all Aim and main market shares this year are:
2016 Magic Formula Picks
| Name | TIDM | Market cap | Price | Fwd NTM PE | Dividend yield | 3-month momentum | Rank |
|---|---|---|---|---|---|---|---|
| Indivior | LSE:INDV | £1.0bn | 140p | 8 | 3.2% | -29% | 1 |
| Gateley | AIM:GTLY | £101m | 96p | 11 | 4.0% | -2.9% | 2 |
| Lakehouse | LSE:LAKE | £62m | 40p | 4 | 4.8% | -58% | 3 |
| Wizz Air | LSE:WIZZ | £990m | 1,750p | 12 | - | -2.8% | 4 |
| RM | LSE:RM. | £109m | 136p | 9 | 3.7% | -15% | 5 |
| Dart Group | AIM:DTG | £772m | 522p | 10 | 0.6% | 16% | 6 |
| Somero Enterprises | AIM:SOM | £76m | 136p | 9 | 4.1% | 3.1% | 7 |
| 888 | LSE:888 | £601m | 168p | 17 | 6.2% | 3.6% | 8 |
| Creston | LSE:CRE | £60m | 103p | 9 | 4.1% | -25% | 9 |
| Poundland | LSE:PLND | £399m | 149p | 12 | 4.0% | -44% | 10 |
| Sprue Aegis | AIM:SPRP | £119m | 260p | 12 | 3.1% | -20% | 11 |
| Hargreaves Services | AIM:HSP | £75m | 236p | 14 | 13% | -18% | 12 |
| XLMedia | AIM:XLM | £139m | 70p | 9 | 7.3% | -1.0% | 13 |
| Character | AIM:CCT | £105m | 490p | 11 | 2.4% | -2.1% | 14 |
| John Wood | LSE:WG. | £2.1bn | 575p | 11 | 3.3% | 10% | 15 |
| De La Rue | LSE:DLAR | £404m | 401p | 12 | 6.2% | -8.6% | 16 |
| McColl's Retail | LSE:MCLS | £136m | 130p | 8 | - | -9.3% | 17 |
| Northgate | LSE:NTG | £447m | 341p | 7 | 4.3% | -14% | 18 |
| Melrose Industries | LSE:MRO | £426m | 294p | 7 | 20% | -84% | 19 |
| Utilitywise | AIM:UTW | £127m | 164p | 9 | 3.1% | -5.4% | 19 |
| Ashtead | LSE:AHT | £4.1bn | 805p | 9 | 1.9% | -16% | 21 |
| Harvey Nash | LSE:HVN | £54m | 75p | 8 | 4.7% | -20% | 22 |
| GAME Digital | LSE:GMD | £181m | 107p | 12 | 14% | -54% | 23 |
| Impellam | AIM:IPEL | £376m | 770p | 9 | 1.8% | 3.3% | 24 |
| Huntsworth | LSE:HNT | £112m | 35p | 12 | 2.9% | -16% | 25 |
| IQE | AIM:IQE | £120m | 18p | 7 | - | -23% | 26 |
| Epwin | AIM:EPWN | £167m | 118p | 10 | 4.8% | -7.7% | 27 |
| WS Atkins | LSE:ATK | £1.1bn | 1,158p | 11 | 3.2% | -8.5% | 28 |
| InterContinental Hotels | LSE:IHG | £5.4bn | 2,274p | 18 | 2.4% | -8.0% | 29 |
| SThree | LSE:STHR | £382m | 296p | 13 | 4.7% | -14% | 30 |
Source: S&P CapitalIQ
15% TRAILING-STOP-LOSS VS BUY-AND-HOLD
2015
| 2015 | Stop-loss | No stop-loss | Max peak-to-trough drop |
|---|---|---|---|
| GLOBO DEAD - 01/12/15 | 9% | -100% | -100% |
| NIGHTHAWK ENERGY | -16% | -84% | -91% |
| JOHNSTON PRESS | -12% | -76% | -80% |
| LAMPRELL | 23% | -29% | -61% |
| FERREXPO | -19% | -70% | -83% |
| NOSTRUM OIL & GAS | 3% | -46% | -57% |
| TAPTICA INTERNATIONAL (DI) | -3% | -47% | -65% |
| HARGREAVES SERVICES | -15% | -59% | -59% |
| ANTOFAGASTA | -9% | -45% | -57% |
| STOCK SPIRITS GROUP | -3% | -36% | -56% |
| SOCO INTERNATIONAL | -16% | -48% | -61% |
| HUNTING | -16% | -43% | -64% |
| CLARKSON | 16% | -8% | -33% |
| PETROFAC | 8% | -13% | -38% |
| AMERISUR RESOURCES | -14% | -35% | -55% |
| CENTRAL ASIA METALS | 11% | -5% | -36% |
| GEM DIAMONDS (DI) | -12% | -29% | -42% |
| IMMUD.SYSTEM HDG. | -17% | -31% | -34% |
| MANAGEMENT CNSL.GP. | 0% | -12% | -29% |
| SYNTHOMER | 19% | 10% | -24% |
| VERTU MOTORS | 11% | 5% | -20% |
| ALLIANCE PHARMA | 51% | 45% | -30% |
| WOOD GROUP (JOHN) | -6% | -11% | -27% |
| XAAR | 20% | 20% | -25% |
| KCOM GROUP | 23% | 23% | -14% |
| SALAMANDER ENERGY DEAD - 03/03/15 | -4% | -4% | -8% |
| SOMERO ENTERPRISES REG S | 16% | 23% | -24% |
| XLMEDIA | -1% | 8% | -29% |
| WATCHSTONE GROUP* | 64% | 104% | -41% |
| KBC ADVANCED TECHS. | 20% | 103% | -15% |
*Includes 90p cash return and 1-for-10 consolidation
2014
| 2014 | Stop-loss | No stop-loss | Max peak-to-trough drop |
|---|---|---|---|
| AFREN DEAD - 10/08/15 | -7% | -95% | -97% |
| CAMKIDS GROUP DEAD - 30/10/15 | -15% | -71% | -86% |
| JOHNSTON PRESS | 4% | -50% | -64% |
| HUNTSWORTH | -15% | -42% | -45% |
| KBC ADVANCED TECHS. | 11% | -13% | -40% |
| MANAGEMENT CNSL.GP. | -16% | -39% | -49% |
| HARVEY NASH GROUP | -7% | -26% | -45% |
| SOCO INTERNATIONAL | -2% | -21% | -46% |
| LADBROKES | -6% | -19% | -39% |
| ANDREWS SYKES GROUP | -5% | -16% | -26% |
| COMMUNISIS | -14% | -23% | -35% |
| CENTRAL ASIA METALS | -9% | -17% | -26% |
| GAMES WORKSHOP | 7% | 1% | -26% |
| QINETIQ GROUP | -11% | -12% | -21% |
| CONNECT GROUP | -15% | -16% | -36% |
| ALLIANCE PHARMA | 2% | 2% | -11% |
| CRESTON | 21% | 21% | -11% |
| BAE SYSTEMS | 23% | 23% | -14% |
| NEXT FIFTEEN COMM. | 80% | 80% | -10% |
| IMPERIAL BRANDS | 34% | 34% | -10% |
| HOMESERVE | 4% | 4% | -15% |
| RANK GROUP | 33% | 33% | -14% |
| KENTZ CORPORATION DEAD - 26/08/14 | 42% | 42% | -14% |
| BRITISH AMERICAN TOBACCO | 23% | 23% | -12% |
| ASTRAZENECA | 6% | 15% | -15% |
| CARILLION | -2% | 8% | -21% |
| EBIQUITY | -4% | 8% | -21% |
| WILLIAM HILL | 0% | 14% | -19% |
| WH SMITH | 0% | 27% | -19% |
| GO-AHEAD GROUP | -7% | 22% | -16% |
2013
| 2013 | Stop-loss | No stop-loss | Max peak-to-trough drop |
|---|---|---|---|
| AMARA MINING | -18% | -73% | -81% |
| ANGLO ASIAN MINING | -17% | -63% | -63% |
| BRIGHTSIDE GROUP DEAD - 25/07/14 | 6% | -23% | -42% |
| NAIBU GLOBAL INTL. DEAD - 23/06/15 | -16% | -44% | -46% |
| COASTAL ENERGY (DI) DEAD - 21/01/14 | -14% | -26% | -44% |
| NEXT FIFTEEN COMM. | -3% | -8% | -38% |
| CHIME COMMS. DEAD - 19/10/15 | 42% | 42% | -12% |
| M&C SAATCHI | 48% | 48% | -13% |
| ASTRAZENECA | 26% | 26% | -13% |
| ATKINS (WS) | 64% | 64% | -11% |
| GVC HOLDINGS | 32% | 32% | -15% |
| WH SMITH | 53% | 53% | -12% |
| QINETIQ GROUP | 12% | 12% | -15% |
| GO-AHEAD GROUP | 49% | 49% | -14% |
| VP | 104% | 104% | -6% |
| MDM ENGINEERING GP.(DI) DEAD - 23/10/14 | -20% | -20% | -32% |
| KCOM GROUP | 27% | 27% | -13% |
| EBIQUITY | 23% | 23% | -5% |
| IMPELLAM GROUP | 14% | 15% | -30% |
| ALLIANCE PHARMA | 2% | 3% | -22% |
| CRESTON | 5% | 9% | -26% |
| AFREN DEAD - 10/08/15 | -17% | -4% | -23% |
| GABLE HOLDINGS | 32% | 54% | -44% |
| CABLE & WIRELESS COMMS. | -4% | 30% | -17% |
| GEMFIELDS | -8% | 30% | -42% |
| XCHANGING | 3% | 45% | -19% |
| HOMESERVE | -13% | 35% | -25% |
| ALTERNATIVE NETWORKS | 11% | 87% | -18% |
| UTV MEDIA | 3% | 85% | -20% |
| IMMUD.SYSTEM HDG. | -15% | 86% | -15% |
2012
| 2012 | Stop-loss | No Stop-loss | Max peak-to-trough drop |
|---|---|---|---|
| GEMFIELDS | 67% | 29% | -40% |
| VALIANT PETROLEUM DEAD - 19/04/13 | 14% | -11% | -40% |
| GULFSANDS PETROLEUM | -15% | -38% | -55% |
| IMMUD.SYSTEM HDG. | 2% | -21% | -48% |
| FERREXPO | -16% | -25% | -59% |
| ANGLO PACIFIC GROUP | -9% | -13% | -35% |
| XCHANGING | 56% | 56% | -13% |
| ASTRAZENECA | 2% | 2% | -14% |
| WILLIAM HILL | 69% | 69% | -8% |
| QINETIQ GROUP | 43% | 43% | -12% |
| ASHLEY(LAURA) HOLDINGS | 30% | 30% | -15% |
| NEXT FIFTEEN COMM. | 6% | 6% | -10% |
| ANDREWS SYKES GROUP | 9% | 9% | -12% |
| GLAXOSMITHKLINE | 3% | 3% | -13% |
| UTV MEDIA | 12% | 16% | -28% |
| XP POWER (DI) | 7% | 11% | -31% |
| JD SPORTS FASHION | -12% | -7% | -30% |
| KCOM GROUP | -2% | 5% | -20% |
| IMPELLAM GROUP | 26% | 39% | -17% |
| BHP BILLITON | -16% | -1% | -23% |
| CLARKSON | 1% | 19% | -17% |
| ATKINS (WS) | -7% | 13% | -21% |
| HALFORDS GROUP | -18% | 4% | -43% |
| LOGICA DEAD - 24/08/12 | 4% | 28% | -38% |
| ALLIANCE PHARMA | -21% | 5% | -27% |
| ANGLO ASIAN MINING | -16% | 11% | -26% |
| WH SMITH | -11% | 27% | -15% |
| HOWDEN JOINERY GP. | 0% | 75% | -16% |
| GVC HOLDINGS | -10% | 69% | -15% |
| PACE DEAD - 05/01/16 | -13% | 153% | -27% |
2011
| 2011 | Stop-loss | No stop-loss | Max peak-to-trough drop |
|---|---|---|---|
| JKX OIL & GAS | -2% | -52% | -64% |
| PACE DEAD - 05/01/16 | -3% | -51% | -81% |
| GRIFFIN MINING | -19% | -32% | -48% |
| SPORTINGBET DEAD - 20/03/13 | -15% | -20% | -53% |
| HALFORDS GROUP | -15% | -20% | -35% |
| JD SPORTS FASHION | -4% | -8% | -45% |
| BHP BILLITON | -8% | -9% | -37% |
| EDUCATION DEV.INTL. DEAD - 13/07/11 | 76% | 76% | -12% |
| NEXT | 33% | 33% | -11% |
| THORPE (FW) | 13% | 13% | -6% |
| EAGA DEAD - 21/04/11 | 72% | 72% | -5% |
| WH SMITH | 11% | 11% | -13% |
| JETION SOLAR HDG.(DI) DEAD - 27/04/11 | 0% | 0% | -6% |
| TIMEWEAVE DEAD - 14/11/12 | -6% | -4% | -15% |
| ANDREWS SYKES GROUP | 6% | 8% | -28% |
| ALLIANCE PHARMA | -11% | -9% | -29% |
| MATCHTECH GROUP | -16% | -13% | -17% |
| HOWDEN JOINERY GP. | -6% | -2% | -27% |
| ANGLO-EASTERN PLTNS. | -6% | -2% | -26% |
| ASHLEY(LAURA) HOLDINGS | -15% | -9% | -37% |
| ASTRAZENECA | -10% | -1% | -20% |
| JAMES HALSTEAD | 4% | 22% | -17% |
| GREGGS | -3% | 15% | -19% |
| ALTERNATIVE NETWORKS | 27% | 53% | -22% |
| ROBERT WISEMAN DAIRIES DEAD - 07/03/12 | -14% | 14% | -34% |
| PAYPOINT | 35% | 64% | -18% |
| MICRO FOCUS INTL. | -29% | 7% | -44% |
| CHINA SHOTO DEAD - 05/05/11 | -8% | 29% | -34% |
| PAN AFRICAN RESOURCES | -5% | 71% | -21% |
Source: Thomson Datastream
