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TRIMESTER 3 2014/2015

RESEARCH REPORT

JOEL GREENBLATT IN VALUE INVESTING: EVIDENCE FROM

MALAYSIA STOCK EXCHANGE

PREPARED BY

TAY WEI CHING

PBS1311153

SUPERVISED BY

DR ONG TZE SAN

SUBMISSION DATE

AUGUST 27TH, 2015

JOEL GREENBLATT IN VALUE INVESTING: EVIDENCE FROM

MALAYSIA STOCK EXCHANGE

By

TAY WEI CHING PBS1311153

for the Degree of Master of Business Administration at the Putra

Business School, University Putra Malaysia

August 2015

ii

DECLARATION

I hereby declare that the project is based on my original work except for quotations and

citations that have been duly acknowledged. I also declare it has not been previously or

concurrently submitted for any other degree at UPM or other institutions.

___________________________________

TAY WEI CHING

Date: 27thAUGUST 2015

iii

Abstract of project paper presented to the Senate of University Putra Malaysia in partial

fulfillment of the requirements for the degree of Master of Business Administration.

APPLICATION OF THE STOCK SCREENING CRITERIA OF JOEL

GREENBLATT IN VALUE INVESTING: EVIDENCE FROM MALAYSIA

STOCK EXCHANGE

By

TAY WEI CHING

August 2015

Supervisor: Dr Ong Tze San

Faculty:

Although value investing has gained popularity around the world and many different

screening rules have been created, however they are usually not a simple process to

screen winning stocks. Therefore, Joel Greenblatt has introduced the Magic Formula to

uncover stocks that are cheap [high Earnings Yield (EY)] and good [high Returns on

Invested Capital (ROIC)] which could be used anytime, even if the market is bearish or

bullish. The main objective of this study is to investigate the capability of Joel

Greenblatts stock screening criteria to produce returns greater than the average market

return across the Malaysian market. Another objective is a test on this formulas

individual criteria, which are the Returns on Invested Capital and Earning Yield to form

their respective portfolios; on whether would they achieve the same objective when used

separately. The steps to screen out the stocks for the magic portfolio were adopted from

Greenblatts The Little Book That Beats the Market, and the FBMKLCI is chosen for

iv

the Malaysian stock market. This study employed the three different screening rules to

screen stocks which cover the period of 15 years, from January 2000 to December 2014.

Three types of methodologies such as Descriptive Statistics, Anderson-Darling Test and

one sample T-test were chosen and tested using the statistical software, Minitab, to

determine whether these portfolios would be able to reap returns significantly higher than

the FBMKLCI. The result of this study shows that, although all three portfolios have

returns that are higher that the market return, however only the Magic Formula Portfolio

(EY + ROIC) is proven to be statistically significant in beating the market returns. In

conclusion, the results of this study support the validity of the Magic Formula in the

Malaysian stock market.

Abstrak kertas projek yang dikemukakan kepada Senat Universiti Putra Malaysia sebagai

memenuhi sebahagian keperluan untuk ijazah Sarjana Pentadbiran Perniagaan

ANTARA KADAR FAEDAH DAN KADAR INFLASI DIJANGKA DI MALAYSIA

Oleh

TAY WEI CHING

August 2015

Penyelia: Dr Ong Tze San

Fakulti:

Walaupun nilai pelaburan telah mendapatkan populariti di seluruh dunia dan banyak

kaedah-kaedah pemeriksaan yang berbeza telah diwujudkan, namun ia biasanya tidak

satu proses yang mudah untuk menyaringi saham yang menguntungkan. Oleh itu, Joel

Greenblatt telah memperkenalkan "Formula Magik" untuk mencari saham yang murah

[Hasil Pendapatan (EY) yang tinggi] dan baik [Pulangan Pelaburan Kapital (ROIC) yang

tinggi] yang boleh digunakan bila-bila masa, walaupun pasaran bulis atau pasaran bearis.

Objektif utama kajian ini adalah untuk menyiasat keupayaan kriteria penyaringan saham

Joel Greenblatt untuk menghasilkan pulangan yang lebih besar daripada pulangan

pasaran purata seluruh pasaran Malaysia. Objektif yang lain adalah ujian kriteria individu

formula ini, iaitu ROIC dan EY untuk membentuk portfolio masing-masing dan menguji

sama ada mereka akan mencapai matlamat yang sama apabila digunakan secara

berasingan Langkah-langkah untuk menyaring saham untuk portfolio ajaib. telah diterima

pakai dari Greenblatt "The Little Book that Beats the Market," dan FBMKLCI dipilih

untuk pasaran saham Malaysia. Kajian ini menggunakan tiga peraturan kriteria saringan

vi

yang berbeza untuk memilih stok dalam rangkuman tempoh 15 tahun, dari Januari 2000

hingga Disember 2014 . Tiga jenis kaedah seperti deskriptif Perangkaan AndersonDarling Ujian dan satu sampel ujian-t telah dipilih dan diuji dengan menggunakan

perisian statistik, Minitab, untuk menentukan sama ada portfolio ini dapat meraih

pulangan yang jauh lebih tinggi daripada FBMKLCI. Hasil kajian ini menunjukkan

bahawa, walaupun ketiga-tiga portfolio mempunyai pulangan yang lebih tinggi pulangan

pasaran, tetapi hanyalah Portfolio Formula Magik (EY + ROIC) terbukti statistik yang

signifikan dalam menewaskan pulangan pasaran. Kesimpulannya, keputusan ini

menyokong kesahihan Formula Magik dalam pasaran saham Malaysia.

vii

ACKNOWLEDGEMENTS

This research paper is made possible through the help and support from everyone,

including my supervisor, family and friends.

First and foremost, I would like to thank Dr. Ong Tze San for lending her advice and all

her valuable feedbacks extended to me in the completion of my project paper based on

duration of timeline provided to us.

Next, please allow me to dedicate my acknowledgment of gratitude towards my family

and friends, especially to Chia Siew Lian whose presence and support has given me

continuous motivation to prepare the paper. The product of this research paper would not

be possible without all of them.

Additionally, I would also like to express my special gratitude to my MBA course mates

at Putra Business School, especially to Gayathree Nambiar and Khor Yen Teng.

From the bottom of my heart, I place on record, my sense of appreciation to one and all,

who directly or indirectly, have lent their hands in helping me going through this journey

of life.

viii

TABLE OF CONTENTS

ABSTRACT. ...................................................................................................................... iv

ABSTRAK ......................................................................................................................... vi

ACKNOWLEDGEMENTS ............................................................................................. viii

LIST OF FIGURES ........................................................................................................... xi

LIST OF TABLES ............................................................................................................ xii

CHAPTER 1 ....................................................................................................................... 1

1.1

INTRODUCTION ..................................................................................................1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

CHAPTER 2 ..................................................................................................................... 10

2.1

INTRODUCTION................................................................................................10

2.2

2.3

2.4

MARKET .....................................................................................................................14

2.6

CHAPTER 3 ..................................................................................................................... 18

3.1

INTRODUCTION ................................................................................................18

3.2

3.3

HYPOTHESES ....................................................................................................19

3.4

3.5

3.6

MEASUREMENT ...............................................................................................21

ix

3.7

3.8

3.8.1

3.8.2

3.8.3

3.9

CHAPTER 4 ..................................................................................................................... 27

4.1

INTRODUCTION ................................................................................................27

4.2

4.3

CHAPTER 5 ..................................................................................................................... 38

5.1

INTRODUCTION ................................................................................................38

5.2

5.3

5.4

REFERENCES ................................................................................................................. 43

LIST OF FIGURES

Figure 4.1: Normality Test of EY+ROIC Portfolio ......................................................... 28

Figure 4.2: Normality Test of FBMKLCI ........................................................................ 29

Figure 4.3: Normality Test of EY Portfolio ..................................................................... 32

Figure 4.4: Normality Test of ROIC Portfolio ................................................................. 33

Figure 4.5: Normality Test of FBMKLCI ........................................................................ 33

xi

LIST OF TABLES

Table 4.1: Descriptive Statistics of EY+ROIC Portfolio ........................................... 27

Table 4.2: Comparison of EY+ROIC Portfolio with FBMKLCI Portfolio ............... 30

Table 4.3: One-Sample T-Test and CI: EY+ROIC, Benchmark ............................... 30

Table 4.4: Descriptive Statistics of the individual financial ratios; EY, ROIC and

FBMKLCI ................................................................................................ 31

Table 4.5: Comparison of EY Portfolio with FBMKLCI Portfolio ........................... 35

Table 4.6: One-Sample T-Test and CI: EY, Benchmark ........................................... 35

Table 4.7: Comparison of ROIC Portfolio with FBMKLCI Portfolio ....................... 36

Table 4.8: One-Sample T-Test and CI: ROIC, Benchmark ....................................... 36

xii

CHAPTER 1

INTRODUCTION

1.1

INTRODUCTION

This chapter provides a general understanding of the research topic of the application

of the stock screening criteria of Joel Greenblatts Magic Formula. First and

foremost, the research background is documented. Secondly, the problem statement

comprising of the practical and literature gaps is developed. Thirdly, the research

questions are developed based on the problem statement. Fourthly, the research

objectives are developed according to the research questions. Fifth, the significances

of this study are explained. Lastly, the construction of this thesis is explained.

1.2

BACKGROUND OF STUDY

called value investing in his book titled the The Intelligent Investor. His books

including the Security Analysis published in 1934 have been the two of the most

famous investing books which is considered as the requisite reading material of any

investors. One of the main contributions of Graham is that he was able to draw the

fundamental distinction between investing and speculations.

The main difference between the two is the amount of risk that is undertaken.

Speculators take high risk in deciding the direction of the trade with the hope of

gaining abnormal return with a shorter time horizon than an investor. On the other

1

hand, the lower risk investors are only seeking a satisfactory return on their capital

based on analysis and fundamentals of the underlying asset in the long run. In other

words, speculators are in for a quick killing by holding assets for a short period of

time and sell them off at a huge profit before moving on to another asset. In fact,

speculators are much more focused on the price action of stocks rather than

understanding the business behind it (FCIC, 2010). As Graham would have put it,

investors would see themselves owning a piece of the business when buying stocks

whereas the speculators would be buying an expensive piece of paper which does

not have any intrinsic value.

Value investing encompasses three main characteristics as defined by Graham and

Zweigh (2003). The first characteristic is that prices of assets are subjected to

significant movement or also known as volatility. Despite this, this brings to the

second characteristics whereby they have fairly stable underlying value that are

measurable with due diligence though not reflected in current market price. Lastly,

the third characteristic is that, the best time to buy is when they are selling

significantly below intrinsic value or what they are really worth based on their

assets.

Value investors look for opportunities whereby prices of assets misalign with their

true values. They care little about pricing as cheap stocks do not mean its a bargain

if there is no value to it. However if it is a valuable stock, chances are one would

have purchased it when it is undervalued or at a cheap price relative to its value. In

that case, one would have gained advantage of its low price and they would have a

lot of staying power as any ups and downs of the stock market would not affect

2

them as they would have taken the least risk in that position. Over a long term

horizon, value investing would be able to create wealth as opposed to the short term

abnormal gains through speculations. This is because if a stock is backed by a

fundamentally strong business, value investors would not be bothered by the

volatility of the prices as these investments would offer tremendous value,

reasonable income and great safety over the long run.

After the stock market crisis, value investing has begun to gain popularity with the

phenomenal success of his mentee, Warren Buffett ever since the approach was

initiated by Benjamin Graham. This philosophy has been tested by numerous

academicians by doing screen tests on companies using certain financial ratios, as a

proxy for value investing. Following the success of this philosophy, there have been

a few well-known figures, being representative value investors who developed their

theories based on Benjamin Grahams theory, such as Peter Lynch and Joel

Greenblatt. Extensive research has been made on the originating philosophy, but

only a few studies have been conducted in testing the theories modified by these

representative value investors.

The purpose of this research is to test Joel Greenblatts stock screening criteria, the

Magic Formula in the context of the Malaysia stock market. The reason that this

model is chosen over various other valuation method is that it is driven by the fact

that his method only focuses on two very simple ratios which is the return of capital

and earnings yield and only by using these indicators that Greenblatt could beat the

market average return. In his book "The Little Book That Beats the Market" he has

shown that by using this simple strategy alone he has achieved annual return of

3

30.8% over the last 17 years (Greenblatt, 2006). According to Graham's definition of

undervalued stocks, however in the current market, it is rare to find many

undervalued stocks compared to his investing days. Besides, it is quite difficult to

come to a definite valuation of the fair value of the business due to differences in

future earning estimations, so different people would have different margin of safety

or different definitions of what a cheap price is for each stocks.

However, Greenblatt has a different definition of buying cheap stocks, he define

cheap stocks as buying businesses via its stocks when it is cheap (low price to

earnings) and good (high returns on capital). Therefore the formula could be used

anytime, even if the market is bearish or bullish and one does not require extensive

knowledge in finance to execute his strategy unlike most other valuation

methodologies. If the strategy is to execute according to the methods proposed by

Greenblatt, we can foresee that the portfolio held for a substantial number of years

would be able to produce above average returns.

1.3

PROBLEM STATEMENT

Although the preponderance of the evidence suggests that value investing stands a

higher chance to profit above the market average return, however a value investors

would need to be willing to hold on to stocks for a longer period than speculators. In

a shorter time horizon, the fluctuation of prices would demotivate investors and there

is great uncertainty to continue to hold on. In fact, speculators would have the

tendency to have short term focus and would have the urge to trade rather than have

the discipline and patience to follow through on their investments long term to

achieve their expected value. This is would lead to investors turning to speculators

half way through due to the lack of patience and understanding that while prices

fluctuate so widely when values cant possibly do so (Carnevale, 2014).

The problem lies when investors become speculators. Most investors would end up

gauging price changes to decide to buy and sell and judge their investment success.

Back in the 1997, speculation became rampant which leads to the infamous internet

bubble. A bubble is formed when there is a positive acceleration of prices of assets

that is unexplainable by its fundamental value. Sooner or later, the price will be

inflated way above its intrinsic values and burst with prices falling back down to

normalized level. Devandran et al. (2015) has discovered that the market stock prices

have deviated about 10.12% from its intrinsic values during this rational speculative

bubble in Malaysia.

This rational speculative bubble is caused by speculators that have deviated from

their rational behavior especially when herding occurs (Cuthbertson, 1996). Prior to

the bubble burst, investors realize that the prices are greatly overvalued, however,

their rationale of staying in the market is that if the bubble continues to expand, the

high returns they make would compensate them for the probability of the upcoming

market crash. In short, they are risking a huge drawdown in case anything goes

wrong that would greatly impact the market as a whole.

Speculators often get preoccupied and distracted by the noises in the market from

the financial analyst or even from their peers. Subsequently, this distraction would

leave speculators making decisions based on fear or greed and they may even be

blinded in the prospect of building a sustainable long term investment plan for the

future. As a matter of fact, speculators do not need to take such a high risk in getting

short term gains if they have the patience, conviction and discipline to practice value

investing.

1.4

RESEARCH OBJECTIVE

This study aims to address the following objectives in determining whether Joel

Greenblatts screening criteria would be applicable to the benchmark index which is

the average market return:

1. To investigate the capability of Joel Greenblatts stock screening criteria to

produce returns greater than the average market return.

2. To compare if the use of the individual financial ratios from Joel Greenblatts

stock screening criteria to form a portfolio that would beat the average

market return.

1.5

RESEARCH QUESTION

In order to achieve the research objectives, the research questions are required as the

following:

1. Is the Joel Greenblatts stock screening criteria form a portfolio capable of

beating the average stock market return?

2. Would the individual financial ratios of the Joel Greenblatts stock screening

criteria be able to form a portfolio which produces greater returns than the

average market return?

1.6

SCOPE OF STUDY

This study will be a quantitative research based on secondary data collected from

Bursa Malaysia according to the rules from Joel Greenblatts Magic Formula

methodology. A portfolio is created by using the top 30 ranked based on both and

individual financial ratios, the Return on Capital and Earnings Yield. The KLCI will

be used as a proxy for market returns to compare with the returns of individual

stocks of individual indicator or a combination of both indicators. The stock market

index will be used as the dependent variable whereas the financial ratios will be the

independent variables. This study will cover the period of 15 years beginning from

January 2000 until December 2014 which will make this study relevant to the

current economic situations.

1.7

SIGNIFICANCE OF STUDY

This study investigates the relationship of the Magic Formulas stock screeners as

independent variable and the stock market index as dependent variables. The stock

screeners which are the two simple financial metrics play an important role to the

market participants such as the investors, academic researchers, and policy makers

and so on.

From the perspective of an investor, the findings of this research would help them to

understand the value of being an investor versus a speculator. There have been

countless researches which suggest that there is a much higher probability of

investors meeting their financial goals as compared to speculators. Moreover, the

perks of being an investor would also mean lesser emotional strains that speculators,

on average have to deal with as they have to respond immediately even for short

term micro market changes, which could distract them from their life priorities.

Thus, investors would be much more aware in making better investing decisions by

understanding the importance of business that affect the stock prices. Therefore,

investors would act much rationally in buying and selling stocks which would help

transmit the market to be much more efficient. Adding a quality component to a

value investing approach is at the core of Mr. Greenblatts Magic Formula.

On the other hand, this research would be significant for the academic researchers as

it would open up possibilities to more in depth study of theories modified from the

original Benjamin Grahams philosophy of Value Investing. These findings would

also improve the understanding and credibility of value investing philosophy in the

academic circles.

8

Last but not least, from the policy makers point of view, it would allow them to

make better decisions in formulating policy which stabilizes the economy and avoid

volatility in stock return. Besides that, this would also help policy makers come up

with campaigns to educate the public on the importance of value investing.

1.8

This paper is organized in the following manner. Chapter 1 highlights the differences

between investors and speculators and how it is important to focus on value

investing. It then focuses on a summary of the methodology that Joel Greenblatt uses

in achieving returns greater than market average. In Chapter 2, review prior literature

on efficient market theory, value investing, earnings yield and return on capital. In

Chapter 3, describes the methodology used in this study. Findings and analysis are

presented in Chapter 4 and concluding remarks followed in Chapter 5.

CHAPTER 2

LITERATURE REVIEW

2.1

INTRODUCTION

In this chapter, important topics regarding the previous studies are reviewed

accordingly. Firstly, the Efficient Market Hypotheses is reviewed. Then, it is

followed by the reviews of the theories of value investing and its stock screening

criteria of Joel Greenblatt, the Magic Formula. Additionally, each individual

financial ratios that make up the Magic Formula. Lastly, a chapter summary is

derived from the summaries of each topics reviewed earlier.

2.2

MARKET EFFICIENCY

In 1970, Fama has developed the Efficient Market Hypothesis on beliefs that the

efficient market exists in the stock market. In essence, this theory explains that stock

market prices would reflect information available in the market accordingly. The

theory plays a great role in this research in understanding the misalignment of prices

from its intrinsic value which allows investors to outperform the market.

According to Fama, there are three forms of EMH which is the weak, semi strong

and strong form. The weak form of EMH dictates that all historical market

information and trading volume are fully reflected in the current stock price. As for

the semi strong EMH, it is built on the basis where all public information are fully

incorporated in the current stock price. Last but not least is the strong EMH whereby

10

both public and private information are reflected in the stock prices. This means that

neither fundamental analysis which analyses the financial information nor the

technical analysis which predicts future prices using historical prices would enable

an investor to generate superior profits. In other words, the theory states that the

stock market is efficient which does not enable one to outperform the market

average.

Indeed there has been a great debate between the academician and practitioners on

the efficiency of the market. Malkiel (2000) firmly stated that the market is indeed

efficient due to the irrationalities of the market participants. His theory has tested

time and is still consistent with his book A Random Walk Down Wall Street,

published in the 1973, which found that the behavior of the stock market is as

random as the act of flipping of a coin. Another prominent researcher who is also a

Nobel Laureate winner, Daniel Kahneman is skeptical of the fact that an investor

could actually beat the market, but rather this factor is contributed to investors

biases by discounting the value of a later reward or better known as hyperbolic

discounting (Kahneman and Tversky, 1979).

On the contrary, many literatures have put forward evidences of market anomalies

and predictable patterns mainly there exists a momentum in the short run (Lo and

McKinley, 1999; Lo, Mamaysky and Wang, 2000). However, in the long run, it has

been discovered that the behavior of the market participants play a huge impact in

causing price irregularities and subsequently, return reversal, mainly due to the act of

being overconfident and overreaction to stock prices (Kahneman and Tversky, 1979;

De Bondt and Thaler, 1985). Therefore, it is found that a group of stock held in a

11

diversified portfolio could actually beat market average return due to the

psychological biases of investors (Daniel, 2001).

2.3

VALUE INVESTING

Benjamin Graham is regarded as the father of value investing theory as he was the

first person to introduce the philosophy of Value Investing in his publication of

Security Analysis in 1934 (Greenwald et al., 2004, Ye, 2013). In his book,

Graham and his coauthor, David Dodd described the approach and their investment

techniques to achieve the success on investing which he complemented in his next

publication, The Intelligent Investor (in 1949). The concept behind his value

investing strategy has been almost purely quantitative valuation. Therefore, he seeks

businesses trading at a discount respective to their earnings multiples, sales and book

value (Graham & Dodd, 1934) and to identify systematic errors in the expectation of

the market (Piotroski, 2000).

The rest was history as Grahams ideals have worked tremendously well for

investors such as Warren Buffett, Walter Scholss and thus this theory has become

the core concept of every fundamental analysis strategies created to this day (Low,

2000). However, as businesses evolve in this fast changing world, Grahams strategy

would have been modified to make valuations practical and meaningful. This is

echoed by the hugely successful Warren Buffett who was quoted to have said Boy,

if I had listened only to Ben, would I ever be a lot poorer where he had discovered

12

the shortcoming of his mentors while although his investments thrive during the bear

markets but suffered losses during market bull runs (Arnold, 2013).

As time goes by, innovation of new stock screening strategies revolves around the

fundamentals of Grahams theory, whereby the theory was once mainly focused on

the quantitative valuation of stock with the use of accounting-based information,

would now require analysis of the qualitative aspect of the stocks. The qualitative

aspect would involve looking into the quality of the business and its future prospects.

2.4

STOCK SCREENING

Stock screening involves figuring how much businesses are worth in a systematic

method, in essence determining the true worth of stocks. It allows one to

differentiate the ultimate winning stocks from the losers. Warren Buffett, who was

mentored by Graham, diversified his portfolio and screen stocks with the focus on

their quantitative aspects whereas his business partner, Charlie Munger focuses on

business competitive advantages and its sustainability (Holloway et al, 2013). The

new value investing approach is different from the original style of Graham. Value

investors have been improving the technique, and several other elements were

included in the criteria for selection of assets.

In stock screening, value investing criteria alone are not sufficient to select value

stock but it should include the element of its holding period. Works of Lakonishoket

al. (1994) and Rousseau & Rensburg (2004) support the notion that a long holding

13

period works in favor of value investing whereby the return increases with a longer

holding period. Oppenheimer (1984) suggested that a screening rule that contains a

combination of criteria can be used to reap different returns. Having more or less

criteria does not necessarily give higher or lower returns. Instead, the researcher

needs to find the best combination that produces the highest return.

has been well documented in a journal published by the American Association of

Individual Investors (AAII) in 1998. The portfolio was first created back in

September 1997 using 15 stock screening strategies developed from the approaches

used by well-known investment professionals and the performance of the investment

is publicly available on their website up till today. The research has been able to

categorize well known successful stock screening into four distinct groups namely

Value, Value and Growth, Sector and last but not least Growth which would serve as

guidelines as the first set of rules in any disciplined investment approaches.

2.5

MARKET

Joel Greenblatt who is the author of The Little Book That Beats the Market came

up with a simple version to screen stocks dubbed the Magic Formula using just

two financial metrics namely the earnings yield and return on capital (Greenblatt,

2006). This valuation method is built on the fundamentals of Grahams value

14

investing theory, but uses a much simplified manner that even his children could

grasp the topic through real life examples even when they are in elementary school.

One key principle of his theory is that prices of stocks fluctuate more than their

value which forms his argument on market inefficiency. Therefore an opportunity

arises for value investors to buy businesses at bargain price before the market

realizes their true worth. Prior to writing this book, Greenblatt and his research team

tested Grahams theory in 1981 and determined how Grahams theory could help

individual investors to outperform institutional professionals in investment as the

professionals managing a humongous amount of fund would not be able to take

advantage of small stocks investment (Greenblatt et al., 1981). One main issue

which was highlighted in both his research and book is that the opportunity to

exploit undervalued stocks would significantly reduce as the investment technique

becomes more well-known and the further computerization makes stocks more

accessible and affordable.

One concern that Greenblatt himself have pointed out is the chances that the formula

being simple and could be easily emulated by the general masses. That would have

led to many investors to exploit this theory or even investing in the same set of

portfolios to the point that there is no longer any opportunity to make superior gains.

However, Greenblatt has pointed out that the theory itself would not work well in the

short time period therefore not many would have persisted long enough to reap the

reward.

15

While this publication has garnered great popularity, however it has also drawn

critics to question the Magic Formula. There are two main skeptics over this Magic

Formula (Gray and Carlisle, 2012). The first popular claim was that the result of the

Magic Formula in the book was a product of data mining whereby the author would

have experimented countless of times and by coincidence, one of his test portfolios

may have beat the market. Secondly, it is claimed that the stocks selected for the

portfolio created could not be emulated due to the fact that the stocks are mainly

illiquid or the stock may be too small to invest in. However, there have been a few

academician who have managed to successfully used the formula to beat the market

average in both developing and emerging markets (Hongratanawong, 2014; Carlisle,

2014, Ye, 2013).

2.6

Overall, Greenblatts theory would involve much more quantitative analysis, which

would have seemed to not take into account the prospect of the business in the long

term. However, Greenblatt has in fact created a system to be able to determine the

fair value of investment that minimizes personal judgement and subjective decisions

(Carlisle, 2014). In this Magic Formula, Joel Greenblatt had chosen Earnings Yield

and Return on Invested Capital as the financial ratios of the screening criteria.

Generally, Earnings Yield (EY) can be obtained using the inverse of Price to Earning

(P/E) ratio; however Greenblatt modified the Earnings Yield as the equation of

Earnings before Interest and Taxes (EBIT) over the Enterprise Value (EV). The

reason that P/E or E/P was not used is because using the calculation of EBIT/EV; we

16

would be able to determine the relative price a company earns over its purchase

price.

As opposed to the P/E ratio, the Earnings Yield would be more accurate because P/E

does not reflect companies that borrows a lot but have little cash therefore it gives a

less distortion of its value for operating earnings (Greenblatt, 2001; Alexander,

2009). The choice of EBIT over the reported earnings of the company is due to the

fact that there may be differences with the taxes and interest rates incurred by the

company. The price of the stock must be seemingly cheap enough as compared

with its peers for the investors.

The return on capital can be determined using the Return on Invested Capital

(ROIC) of the business. The Return on Invested Capital is calculated using the

equation of the differences between the net income and dividend divided by total

capital. It represents how efficient a company is using its capital to get its returns

(Investopedia,n.a.).

It boils down to how much you are getting back from your investment into the

business. ROIC builds on the notion on how well the business is doing in rewarding

the capital that you have invested in. Therefore owning a share in a good business

would allow bring a higher rate of return than a business which is not doing well.

What makes a business either good or bad boils down to the quality of its products or

services, the loyalty of its customers, the value of its brands, the efficiency of its

operations, the talent of its management, the strength of its competitors, or the long

term prospects of its business (Hongratanawong, 2014).

17

CHAPTER 3

DATA AND RESEARCH METHODOLOGY

3.1

INTRODUCTION

This chapter delves into the research methodologies used to study the relationship

between the Joel Greenblatts stock screening criteria and the individual financial

ratios with the market stock returns. First and foremost; the conceptual framework is

constructed. Secondly the research design of this study is explained and the target

population of this study is identified. Thirdly, measurements of the variables in this

study are developed. Fourthly, data collection method of this study is developed.

Fifthly, the analysis tool and analyses in analyzing the data obtained are identified.

3.2

CONCEPTUAL FRAMEWORK

Figure 3.1 presents the framework of this study whereby three different portfolios will

be formed using the financial ratios in the Magic Formula as the screening criterias

and the returns are compared with the benchmark index which is the FBMKLCI

returns.

Figure 3.1: The Conceptual Framework

Portfolios (formed using

ROIC and/or EY)

Return)

18

3.3

HYPOTHESES

The hypotheses are used to investigate the research question. The hypothesis is

adopted from previous literatures to test the hypothesis on a single mean using the

returns of each year and measures the significance of this return against the market

average (Chang, 2011; Ye, 2013).

Ho: Return of the portfolio is equal to or lower than the return of the market

Ha: Return of the portfolio is significantly higher than the return of the market

3.4

RESEARCH DESIGN

The research design is vital in planning out the relevant research method to be used to

carry out a study (Babbie, 2010). This is an exploratory analysis to determine the

validity of Greenblatts screening criteria on the stock market in Malaysia. It is a

quantitative research with the deductive approach whereby the secondary data sources

collected from reputable source such as Datastream and Bursa Malaysia are used to

prove the theory. The theory involved in this study is the value investing theory which

is a popular way of investment. This research will replicate the study conducted by

the author himself but on a different context which is the Malaysian stock exchange.

A time-series will be employed into this study and analyzed using the suitable

analysis.

19

3.5

TARGET POPULATIONS

The target populations in this study involve obtaining yearly historical data from the

Bursa Malaysia stock exchange. The population target is done according to the

specification provided by the author himself, Greenblatt. This study is done by

ranking the top 30 companies according to two different variables which is the both

either or both the financial ratio, Earnings Yield (EY) and Returns on Invested Capital

(ROIC). The rationale of using 30 stocks in a portfolio is optimal to minimize

unsystematic risk and there would not be any significant diversification effect by

adding another stock into the portfolio (Gupta & Khoon, 2001; Sareewiwatthana,

2013; Larkin, 2009). The portfolios will be back tested for a period of 15 years from

January 2000 to December 2014. The choice made for this period length is based on

similar previous literatures which covers similar period length between 10 to 20 years

(Hongratanawong, 2014; Chang, 2011; Sareewiwatthana, 2013; Ye, 2013).

These stocks would be placed in a portfolio and its returns are compared to the market

average which is the FBMKLCI. The FBMKLCI stock return is the only dependent

variable of this study. FBMKLCI is a capitalization-weighted stock market index. The

stock index is made up of the top 30 largest stocks by their market capitalization. The

components of this index are designed according to its investability, liquidity,

transparency, availability and according to industry classification benchmark for the

purpose of index tracking funds, derivatives and as a benchmark of performance

(FTSE Factsheet).

20

3.6

MEASUREMENT

The measurements of the variable are done using the stock screening criteria of the

Return on Invested Capital and Earning Yield. The formula for the Return of Invested

Capital calculated using the Datastream application is shown below:

Return on Invested Capital= (Net Income Bottom Line + ((Interest Expense on

Debt - Interest Capitalized) x (1-Tax Rate))) / Average of Last Year's and Current

Years (Total Capital + Short Term Debt & Current Portion of Long Term Debt) x100

On the other hand, the formula of the Earnings Yield is the ratio of EBIT to the

Enterprise Value. The enterprise value is the equitys market value and the netinterest bearing debt whereby the formula used is as follow:

Enterprise Value= Market Capitalization (fiscal year end date) + Preferred Stock +

Minority Interest + (Total Debt-Cash)

Cash represents Cash & Due from Banks for Banks, Cash for Insurance Companies

and Cash & Short Term Investments for all other industries. Earnings before interest

and Taxes (EBIT) calculated by Datastream as the enterprises earnings before

interest and taxes, are using pre-tax income with the addition of interest expense on

debt and then minus off the interest capitalized.

21

3.7

Joel Greenblatt on a yearly basis covering from January 2000 to December 2014 in

Malaysia. Firstly, the market capitalization of all stocks under the Bursa Malaysia is

determined for each year and each of its mean value is calculated. In the original rule

of the formula, the market capitalization of the stocks qualified for the formation of

the portfolio needs to have a minimum of USD5 million, however there is no basis or

calculation on how to derive to that value when used in stock markets in other

countries. Therefore, this requires modification for this study whereby individual

stocks in each year with market capitalization below the respective mean value will be

removed and not considered into the formation of the portfolios.

Then, the yearly stocks were separately ranked for two financial ratios [Return On

Invested Capital (ROIC) or Earnings Yield (EY)] both from the highest to the lowest.

For the financial metrics, the return of invested capital, the company stock with the

highest return of capital is assigned a rank of 1 and the lowest return on invested

capital would be assign the last figure, with the top 30 ranking stocks would be picked

into forming the ROIC Portfolio. The same procedure is done using the earnings yield

whereby the highest earnings yield is assign a rank of 1 with the lowest earnings yield

be assigned the last figure hence, with the top 30 ranking stocks would be picked in

creating the EY Portfolio.

Another combined portfolio will be formed by summing up both the two metrics

ranks therefore creating the EY+ROIC Portfolio. For example, the stock with both the

rank of 121 in returns of invested capital and the rank of 50 in earnings yield would

22

have the new combined rank of 171 (121+50). The top 30 ranking stocks would then

be picked from this new list to forming the EY+ROIC Portfolio.

All information from the will be extracted from the online Thomson Reuters Data

Stream subscription database which would include all public corporations listed in the

Bursa Stock Market. All the data will be analyzed using the Minitab statistical

software using the several tests to make a comparison between financial metrics and

stock return performance.

3.8

The research hypotheses developed in this study were tested and analyzed using the

statistical test in order to determine the financial metrics valuation in Malaysia stock

market returns. The analysis software tools that were used in this study were the

Microsoft Office Excel and Minitab software.

Firstly, the total returns of the portfolios would be computed according to the

following formula according to the Datastream software:

Total Returns= Dividend Paid + Capital Gain

Beginning Share Price

whereby, the capital gain is obtained by finding the differences between last price of

the next year with the last price of the current year. The portfolio returns will be

compared to the returns of the market average return which would be the Malaysia

stock market index, FTSE Bursa Malaysia KLCI (FBMKLCI),

23

3.8.1

DESCRIPTIVE STATISTICS

quantitative manner, as part of a more extensive statistical analysis (Mann and Prem,

1995). The description of the variables would include mean, median, mode and

measure of dispersion of data such as the variance and standard deviation. This basic

analysis would give an overview of the portfolios characteristics and allow us to

compare them with the FBMKLCI.

3.8.2

NORMALITY TEST

normal probability plot to examine whether the observation follows or does not follow

a normal distribution (Babbie, 2010). The hypothesis for this normality test is as

follows:

Ho: Data follows a normal distribution if p-value is more than 0.05

Ha: Data do not follow a normal distribution if p-value is less or equal to 0.05

If p value is more than 0.05, the data follows a normal distribution whereas if the p

value is less than 0.05, the data is not normally distributed. However, in a normal

distributed data, its distribution may either be symmetrical or assymetrical. In

asymmetrical data distribution, skewness would measure the deviation of distribution

from symmetry, with a positive value implying a right side/tailed distributed while a

negative value would imply a left side/tailed distribution. As for kurtosis, a figure

24

above 3 would indicate that the data is fat tailed distribution whereas a figure lesser

than 3 would mean that the data is thin tailed distribution.

3.8.3

HYPOTHESIS TEST

This research is done to determine whether the returns from the portfolio created from

the screening criteria would be higher than the market average. The one sample t-test

statistic would be used to determine their statistical significance of this studys

hypothesis (Walpole et al., 2002) and previous studies have utilized this analysis tool

to test their hypothesis (Ye, 2013; Chang, 2011).

The returns for the three portfolios formed are measured using the t-test statistic to

test the hypothesis to establish the significance between the return of the portfolios

and the return of the FBMKLCI index. In determining the significance of the returns,

the t-test will either reject or accept the hypothesis of this study.

The following test equation is as follow

Formula of t-statistic

X-

s_

(n-1)

where,

x = mean return of the sample

= mean return of the stock index

s= standard deviation of the sample

n= number of stocks in the sample

25

3.9

CHAPTER SUMMARY

In a nutshell, research design plays a vital role in conducting this study. This

exploratory study employs the deductive approach in testing the Joel Greenblatts

screening criteria in getting a portfolio return that beats the stock return. The steps on

forming the portfolios are discussed and methodologies used are presented in the

remaining parts of the chapter.

26

CHAPTER 4

RESULTS AND DISCUSSION

4.1

INTRODUCTION

This chapter elaborates on the results of the study in determining the returns of the

portfolios created using the Magic Formula over the returns of the market average,

FMBKLCI, Malaysia. Hence, several statistical measures will be presented within this

chapter, which are linked to the research objectives and hypothesis specified earlier.

Three different methodologies will be used in this test and the results will be

discussed according to the analysis of descriptive analysis, normality test and lastly, ttest to test the hypothesis of this study.

4.2

STATS

EY+ROIC

FBMKLCI

MEAN

1416

1156.8

MAX

2782

1861.6

MIN

615

657.7

VARIANCE

472199

162080

STANDARD

687

403

DEVIATION

27

Table 4.1 shows the descriptive analysis summary of the returns from the EY+ROIC

Portfolios which is the Magic Formula as compared with the average market return,

FBMKLCI. It is found that the EY+ROIC Portfolio have a mean of 1416 which is

above the market mean return of 1156.8. The minimum value of this portfolios and

market returns are similar which is between the values of 615 to 657.7 but it has a

maximum value of all that are much higher than the market return maximum value by

at least 49%.

The EY+ROIC Portfolio resulted with a standard deviation of 687% and variance of

472199 whereas the FBMKLCI has a standard deviation of 403% and variance of

162080. This shows that there is a higher variability and less sensitive precision

between the returns of the stocks selected using the Magic Formula than the returns of

the stocks in FBMKLCI. This shows that the custom portfolio has a higher risk profile

than the FBMKLCI index.

Figure 4.1: Normality Test of EY+ROIC Portfolio

Summary for Return+ROIC

A nderson-D arling N ormality Test

500

1000

1500

2000

A -S quared

P -V alue

0.66

0.066

M ean

S tD ev

V ariance

S kew ness

Kurtosis

N

1415.7

687.2

472199.1

0.777640

-0.538016

15

M inimum

1st Q uartile

M edian

3rd Q uartile

M aximum

2500

615.3

826.9

1385.7

2056.3

2781.5

1035.2

1796.3

826.9

1871.9

9 5 % C onfidence Inter vals

503.1

1083.7

Mean

Median

1000

1250

1500

1750

2000

28

Summary for Benchmark

A nderson-D arling N ormality Test

750

1000

1250

1500

1750

A -S quared

P -V alue

0.41

0.308

M ean

S tD ev

V ariance

S kew ness

Kurtosis

N

1156.8

402.6

162079.9

0.49218

-1.05653

15

M inimum

1st Q uartile

M edian

3rd Q uartile

M aximum

657.7

800.2

1109.4

1483.7

1861.6

933.9

1379.8

806.0

1437.5

9 5 % C onfidence Inter vals

294.7

634.9

Mean

Median

800

900

1000

1100

1200

1300

1400

Based on the Figure 4.1 and Figure 4.2, it is shown that the EY+ROIC Portfolio and

the FBMKLCI has an asymmetrical distribution with positively skewed distribution

(skewness > 0, asymmetrical right sided/ tailed distribution, mean > median). Both

data has kurtosis of less than 3 hence they have a thin tailed distribution. Using a

significance level of 0.05, the Anderson-Darling Normality Test (A-Squared=0.66, PValue=0.066) indicates that the EY+ROIC portfolio follows a normal distribution as

its p-value is more than 0.05. This would mean that the Magic Formula was being

able to pick winning stocks that are consistently similar to the mean of its portfolio.

Although the standard deviation is higher than the FBMKLCI index, however this

would also mean that the differences of returns are much more predictable and not

widely spread out. Therefore there is a lower probability that this method detect

stocks that have abnormal growths.

29

Year

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

EY+ROIC

826.571

615.2526667

794.7043333

827.0326667

826.8603333

934.07

1385.655667

1537.711667

1438.588333

965.9696667

1562.587

2139.547

2543.603667

2781.516

2056.335333

FBMKLCI

800.23

657.72

729.99

727.46

815.62

937.04

946

1288.34

1109.43

1188.57

1360.15

1483.67

1652.9

1793.73

1861.58

Differences

26.341

-42.4673

64.71433

99.57267

11.24033

-2.97

439.6557

249.3717

329.1583

-222.6

202.437

655.877

890.7037

987.786

194.7553

Test of mu = 1156.8 vs not = 1156.8

N

Mean

StDev

SE Mean

15

1416.0

166.0

42.9

95% CI

(1324.1, 1507.9)

T

6.05

P

0.000

As for the portfolio created using both EY+ROIC ratios shown in Table 4.2, 12 out of

the 15 year period has returns that outperformed the market return. As shown in Table

4.3, using the t-test at the significance level of 95%, the p-value for the EY+ROIC

Portfolio is less than the alpha value of 0.05. This means we cannot trust that the data

is an actual representative of its population with the probability of 95%. Hence the

null hypothesis should be rejected that at least one significant (p<0.05) difference

exists between the means of the sample and population with probability of 95%.

Similar test results have been obtained using the Magic Formula in other stock

markets that outperformed their respective market index average.

30

4.3

Table 4.4: Descriptive Statistics of the individual financial ratios; EY, ROIC and

FBMKLCI

STATS

EY

ROIC

FBMKLCI

MEAN

1441

1909

1156.8

MAX

3626

4163

1861.6

MIN

679

693

657.7

VARIANCE

676937

1401570

162080

STANDARD

823

1184

403

DEVIATION

The Figure 4.4 shows the descriptive analysis summary of the returns of the EY and

ROICE portfolios as compared to the average market return, FBMKLCI. It is found

that the EY portfolio has a mean return of 1441 while ROIC portfolio has the highest

mean of 1909. Both mean returns are above the market mean return of 1156.8. The

minimum value of all portfolios and market returns are similar which is between

657.7 and 693 but the maximum values of all both newly formed portfolios are much

higher than the market return maximum value by at least double for the EY portfolio

while the ROIC portfolio has the maximum value of more than 124%. From the

details above, it shows that the two financial ratios have the tendency to pick better

performing stocks than the market index would.

The EY portfolio resulted in an 823% standard deviation and a variance of 676937,

while ROIC portfolio resulted with 1184% whereas the FBMKLCI has a standard

31

deviation of 403% and a variance of 1401570. This shows that the portfolios tend to

have variability and less sensitive precision as compared to the market average return.

From the details above, it shows that the two financial ratios have much higher risks

than the FBMKLCI index due to the returns was having at least doubled the

differences. This would mean that the ROIC portfolio may appeal to a high risk

tolerance as it has a better chance to pick individual high performance stocks rather

than consistent winning stocks.

Summary for Return

A nderson-Darling N ormality Test

500

1000

1500

2000

2500

3000

A -S quared

P -V alue

1.08

0.005

M ean

S tD ev

V ariance

S kew ness

Kurtosis

N

1441.3

822.8

676936.8

1.74181

2.88525

15

M inimum

1st Q uartile

M edian

3rd Q uartile

M aximum

3500

679.5

800.8

1220.7

1747.0

3625.7

985.7

1896.9

871.9

1711.3

9 5 % C onfidence Inter vals

602.4

1297.6

Mean

Median

1000

1200

1400

1600

1800

2000

32

Summary for ROIC

A nderson-Darling N ormality Test

1000

2000

3000

A -S quared

P -V alue

0.89

0.017

M ean

S tDev

V ariance

S kew ness

Kurtosis

N

1909.2

1183.9

1401570.1

0.888550

-0.599391

15

M inimum

1st Q uartile

M edian

3rd Q uartile

M aximum

4000

692.7

970.9

1458.1

2581.9

4162.9

1253.6

2564.8

972.7

2539.2

9 5 % C onfidence Inter vals

866.7

1867.1

Mean

Median

1000

1250

1500

1750

2000

2250

2500

Summary for Benchmark

A nderson-Darling N ormality Test

750

1000

1250

1500

1750

A -S quared

P -V alue

0.41

0.308

M ean

S tDev

V ariance

S kew ness

Kurtosis

N

1156.8

402.6

162079.9

0.49218

-1.05653

15

M inimum

1st Q uartile

M edian

3rd Q uartile

M aximum

657.7

800.2

1109.4

1483.7

1861.6

933.9

1379.8

806.0

1437.5

9 5 % C onfidence Inter vals

294.7

634.9

Mean

Median

800

900

1000

1100

1200

1300

1400

33

Both the EY and ROIC portfolios and the FBMKLCI shown in Figure 4.3, 4.4 and 4.5

respectively has an asymmetrical distribution with positively skewed distribution

(skewness > 0, asymmetrical right sided/ tailed distribution, mean > median). Only

the EY Portfolio has a kurtosis of more than 3 hence it has a fat tailed distribution

whereas the ROIC portfolios and FBMKLCI data have thin tailed distribution

(kurtosis<3).

Using a significance level of 0.05, the Anderson-Darling Normality Test for EY

Portfolio (A-Squared=1.08, P-Value=0.005) and ROIC Portfolio (A-Squared=0.89, PValue=0.017) both having a p value less than 0.05, therefore indicating that both

portfolios do not follow a normal distribution. Another thing to note is that there is an

outlier in the EY Portfolio. The non-normal distribution and presence of outlier shows

that the stock market returns do not always follow a normal distribution.

Although it is agreed that stock market returns do form a normal distribution, however

there are times that the distribution is skewed and there exist the fat tails which

indicates a higher probability of abnormal returns (Richards, 2010; Christopher, n.d.).

These fat tails are also known leptokurtosis which is linked to black swan events that

may greatly affect the returns (McKinsey Consulting, 2009). The Black Swan Theory

which was created by Nassim Nicholas Taleb, became popular as it challenges the

theories of traditional investment methods in viewing risk and return in the Modern

Portfolio Theory (MPT). This supports the notion that both individual EY financial

ratios may have been able to pick effectively picked stocks that responded well

fundamental factors of the business and its environment. This is shown that there exist

outliers in the year 2014 which are due the Malaysian economy in 2014 being robust

34

and outperforming its regional counterparts with a Gross Domestic Product (GDP) at

a 4 year high of 6% (McKinsey Consulting, 2009;Chong, 2014).

Year

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

EY

765.5027

679.455

781.1087

800.7757

997.745

1121.342

1246.754

991.143

1378.161

1220.714

1651.379

1760.652

1747.034

2852.09

3625.725

FBMKLCI

800.23

657.72

729.99

727.46

815.62

937.04

946

1288.34

1109.43

1188.57

1360.15

1483.67

1652.9

1793.73

1861.58

Differences

-34.7273

21.735

51.1187

73.3157

182.125

184.302

300.754

-297.197

268.731

32.144

291.229

276.982

94.134

1058.36

1764.145

N

15

Mean

1441

StDev

SE Mean

95% CI

823

212

(985, 1897)

T

1.34

P

0.202

35

Year

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

ROIC

881.2407

692.7287

970.911

885.772

986.3897

975.6467

1245.385

1697.574

2111.69

2467.537

1458.112

2581.939

4162.926

3692.87

3827.426

FBMKLCI

800.23

657.72

729.99

727.46

815.62

937.04

946

1288.34

1109.43

1188.57

1360.15

1483.67

1652.9

1793.73

1861.58

Differences

81.0107

35.0087

240.921

158.312

170.7697

38.6067

299.385

409.234

1002.26

1278.967

97.962

1098.269

2510.026

1899.14

1965.846

Test of mu = 1156.8 vs not = 1156.8

N

15

Mean

1909.0

StDev

286.0

SE Mean

95% CI

73.8

(1750.6, 2067.4)

T

10.19

P

0.000

In Table 4.5, the return of the EY Portfolio outnumbered the average market return 13

out of the 15 year period of this research. On the other hand, in Table 4.7 for the

ROIC Portfolio, all 15 year period returns outnumbered the average market return.

Using the t-test at the significance level of 95% as shown in Table 4.6 and 4.8, the pvalue for the EY Portfolio is more than 0.05 whereas the ROIC Portfolio is less than

0.05.

Therefore, for the EY Portfolio, we can 95% be sure that the data follow the

population with a probability of 95%. Hence, the null hypothesis is accepted that no

36

significant (p>0.05) difference exists between the means of the sample and population

with the probability of 95%.

On the other hand, for the ROIC Portfolio, we cannot trust that the data is an actual

representative of its population with the probability of 95%. Hence the null hypothesis

should be rejected that at least one significant (p<0.05) difference exists between the

means of the sample and population with probability of 95%.

37

CHAPTER 5

CONCLUSION AND RECOMMENDATION

5.1

INTRODUCTION

This chapter will discuss the overall findings through its analysis and include them

with some relevant discussions. At the end of this chapter, some recommendations on

policy and strategy changes are laid out.

5.2

SUMMARY OF FINDINGS

that have intrinsic values below the market value. Over time, these differences will

eventually reduce as the stock prices evolve to meet their intrinsic values. However,

there is still a debate over the effectiveness of value investing although there has been

numerous studies which proves that value investing are able to produce returns above

market average returns.

In this study, the original Magic Formula which combined both Earnings Yield and

Return on Invested Capital ratios as its screening criteria were tested. Results for this

test has shown that the portfolio formed between the year 2000 to 2014 using the

Magic Formula (EY+ROIC) was able to get returns that is significantly higher than

the market average which is the FBMKLCI. Similarly, two other tests have been done

to determine whether the individual financial ratios of the Magic Formula perform as

38

well as the combined ratios. The results have shown that although both the EY and

ROIC Portfolios are able to form portfolios that beat market average returns, however,

the ROIC Portfolios returns are statistically significant while the EY Portfolios is

not statistically significant.

This is due to the high variability of the returns of the stocks picked for the EY

Portfolio. Overall, the original Magic Formula utilizes the best of both equations and

the combination of EY and ROIC works much better on a psychological perspective

and consistently in getting returns higher than the market average returns. This would

allow investors with much lower risk tolerance to use the original Magic Formula to

obtain consistent flow of positive returns than the other two individual ratios.

In the Anderson Normality test conducted for all three portfolios have shown that

there is a tendency that they do not always for a normal distribution, with only the

EY+ROIC Portfolio having a normal distributed return. This is due to the fact that the

stock market is unpredictable and is greatly influenced by the Black Swan events.

Other results may have predicted that the individual EY Portfolio and ROIC Portfolio

have very high variability in their returns and therefore these portfolios may have

higher risk profiles as the difference of the returns is spread out wide apart. As for the

EY Portfolio, it has been shown that these screening criteria tend to pick stock returns

with abnormally high return that would compensate on the variability of the returns in

the portfolio.

Thus, the results obtained were able to indicate that Joel Greenblatts screening

criteria is feasible to be used in our Bursa Malaysia stock exchange. In addition to the

simplicity of these screening criteria of Joel Greenblatt and testing the individual

39

financial ratios, this research is able to benefit investors to take charge of their

investments. Investors no longer need to depend on much advanced screening criteria

which they may not have the fundamentals of understanding or require the need to

hire third party fund managers which would subsequently reduce the cost of hiring or

in getting sophisticated software therefore maximizing their investment returns. In

essence, the Magic Formula consists of the right formula to discover good performing

companies that are undervalued which would fit well with the value investing

philosophy that is created by Benjamin Graham.

5.3

LIMITATION OF STUDY

A study is without its limitation therefore the hurdles that have been faced in

undertaking this study are discussed. Firstly, the Bursa Malaysia is a much smaller

market and less traded than the US market as tested by Joel Greenblatt in the creation

of this Magic Formula. This leads to the difficulty of setting an ideal way to prescreen

the portfolio due to the vast differences in market capitalization filter as there were no

instructions on how it is derived.

Secondly, the study only concentrates only on the original Magic Formula and an

extension on its individual financial ratios in forming the portfolio for comparison

with FBMKLCI. While, there are numerous other potential financial ratios that share

the same characteristics and may be very well fit into consideration. Thus, it is

necessary in the future to include other ratios and other factors that may potentially

maximize the returns of the custom portfolios.

40

Thirdly, this study is only limited in determining the returns of custom portfolios

which does not take into consideration the risk factor. Undertaking a risk return

analysis would help investors understand the risk level that they are about to take in

order to pursue for returns higher than the market index.

Last but not least, the duration of this study is only limited to 15 years between the

year 2000 to 2014. Different duration variation and comparisons may be able to

provide a better view on whether the returns are sustainable over different time

periods as these periods may fall on different segments of the business and the market

cycle.

5.4

Further study should expand on the time duration of the data samples that may play a

huge part in dictating returns. This could actually help to improve the reliability and

validity of the findings this would factor in the different business and market cycle

and also create more credentials with more proofs of significantly higher returns. This

includes different holding periods in determining whether the high financial ratios

could reap sustainable rewards over a longer period for the business.

Furthermore, it is recommended that the future studies would include testing the

formula to understand its risk and return so that investors could know what level of

risks that they need to have to get the high returns. High returns are usually known to

come with high risks, therefore, we would need to know whether the return worth the

41

risk that is taken. This would allow investors to be more prepared with their risk

management to maximize their returns.

Further studies can employ relationship tests to determine which financial ratios (EY

and ROIC) from the Magic Formula plays a much significant part in dictating the

returns of the portfolio. Besides that, other factors can be determined on how they

influence the efficiency of this Magic Formula. Thus, this study would serve as the

baby steps into exploring deeper into the potential and opportunities in return

maximization using the Magic Formula.

42

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47

APPENDICES

48

Descriptive Statistics: EY, ROIC, Return+ROIC, Benchmark

Total

Variable

Count

N* CumN

Percent

CumPct

Mean

EY

15

15

ROIC

15

15

Return+ROIC

15

Benchmark

15

SE Mean TrMean

StDev

15

100

100

1441

212

1332

823

15

100

100

1909

306

1829

1184

15

15

100

100

1416

177

1372

687

15

15

100

100

1157

104

1141

403

Sum of

Variable

EY

Variance

676937

CoefVar

57.08

Sum

21620

Squares

40637534

Minimum

679

Q1

Median

801

1221

Q3

1747

ROIC

1401570

62.01

28638

74298217

693

971

1458

2582

Return+ROIC

472199

48.54

21236

36675316

615

827

1386

2056

Benchmark

162080

34.80

22342907

658

800

1109

1484

17352

N for

Variable

Maximum

Range

IQR

Mode Mode

Skewness

Kurtosis

MSSD

EY

3626

2946

946

1.74

2.89

83753

ROIC

4163

3470

1611

0.89

-0.60

204509

Return+ROIC

2782

2166

1229

0.78

-0.54

70865

Benchmark

1862

1204

683

0.49

-1.06

10763

49