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In writing the last post, I thought I'd link an article that might encourage people disheartened by the current investing environment.

Key principles of the Magic Formula method include a preference for:

1. value stocks -- from the website FAQ: "In the case of the Magic Formula system, we are screening for stocks with low P/E ratios ("cheap stocks") that also achieve high returns on capital ("good companies").

2. small-caps -- the screener starts at 50m market cap, which is 'micro' today. The FAQ adds, "Our data shows that, large companies tend to be less volatile than small companies. In an effort to reduce volatility, it may be best to choose companies with larger market capitalizations (over $1 billion)." But even $1B is not big anymore. The company with the *lowest* market cap in the S&P500 is SL Green Realty (SLG) with a market cap of $3.47B, as of Oct 16, 2020. You’d have to enter a number of over 20000 into the screener to even limit to the top 250 companies by size, and the website’s input box can’t display a number that big…

3. diversification — from the website “How it Works” tab: “Eliminate any companies you do not want to own for any reason; however, you should keep at least 20 stocks in an effort to properly manage risk.”

These three factors are listed as reasons for underperformance in a recent Bloomberg article subtitled “Diversified portfolios can’t keep up with a market supercharged by a few tech stocks.”

It notes, “A 60/40 portfolio of global stocks and bonds has returned a respectable 8.4% annually over the past five years, but also a heart- breaking 6.2 percentage points a year less than the S&P 500. And that’s probably the best case. Those who also dabbled in value stocks, small companies, hedge funds or energy-related real assets fared even worse”…and “Many diversified portfolios would have suffered even more if not for the success of bonds and private equity.”

The article indicates diversification has been a failure. If you didn’t own these ten, you missed out on HALF the gains of the past 5 years:
1. Amazon com Inc.,
2. Apple Inc.,
3. Microsoft Corp.,
4. Nvidia Corp. and
5. Advanced Micro Devices Inc. in the U.S.;
6. Alibaba Group,
7. Tencent Holdings Ltd. and
8. Kweichow Moutai Co. in China;
9. Shopify Inc. in Canada; and
10. Magazine Luiza SA in Brazil

Frankly, I’d never even heard of Kweichow Moutai or Magazine Luiza before the article. I personally bought (and most importantly held!) Apple and Microsoft when they appeared on the Magic Formula list way back in 2013. Even if they were lucky enough to buy these two, I suspect most Magic Formula investors would have rotated out of them by 2015 or so. I recognize my luck here, but even so I am underweight compared to the present-day S&P500. Apple is NOT 6.7% of my holdings, nor MSFT 5.7%.

Fortunately, things will change. “Interest rates have little room to fall further and private equity is awash with money chasing too few deals, which is stretching valuations and compromising future returns.” IMO bond and private equity dollars will start flowing downstream to where MF lives, value and small caps. I think the next five years will be very different.
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