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PROJECT PAPER (GSM5991)

TRIMESTER 3 2014/2015

RESEARCH REPORT

APPLICATION OF THE STOCK SCREENING CRITERIA OF


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

APPLICATION OF THE STOCK SCREENING CRITERIA OF


JOEL GREENBLATT IN VALUE INVESTING: EVIDENCE FROM
MALAYSIA STOCK EXCHANGE

By
TAY WEI CHING PBS1311153

Project Paper Submitted in Partial Fulfillment of the Requirements


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:

Putra Business School

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

SATU KAJIAN EMPIRIKAL BERDASARKAN JANGKA PANJANG DI


ANTARA KADAR FAEDAH DAN KADAR INFLASI DIJANGKA DI MALAYSIA
Oleh
TAY WEI CHING
August 2015
Penyelia: Dr Ong Tze San
Fakulti:

Putra Business School

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
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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.

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TABLE OF CONTENTS

DECLARATION ............................................................................................................... iii


ABSTRACT. ...................................................................................................................... iv
ABSTRAK ......................................................................................................................... vi
ACKNOWLEDGEMENTS ............................................................................................. viii
LIST OF FIGURES ........................................................................................................... xi
LIST OF TABLES ............................................................................................................ xii
CHAPTER 1 ....................................................................................................................... 1
1.1

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

1.2

BACKGROUND OF STUDY ................................................................................1

1.3

PROBLEM STATEMENT ....................................................................................4

1.4

RESEARCH OBJECTIVE .....................................................................................6

1.5

RESEARCH QUESTION ......................................................................................7

1.6

SCOPE OF STUDY ...............................................................................................7

1.7

SIGNIFICANCE OF STUDY ................................................................................8

1.8

CONSTRUCTION OF THE THESIS....................................................................9

CHAPTER 2 ..................................................................................................................... 10
2.1

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

2.2

MARKET EFFICIENCY .....................................................................................10

2.3

VALUE INVESTING ..........................................................................................12

2.4

STOCK SCREENING ........................................................................................13

2.5 JOEL GREENBLATT THE LITTLE BOOK THAT BEATS THE


MARKET .....................................................................................................................14
2.6

THE MAGIC FORMULA STOCK SCREENER CRITERIA .........................16

CHAPTER 3 ..................................................................................................................... 18
3.1

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

3.2

CONCEPTUAL FRAMEWORK ........................................................................18

3.3

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

3.4

RESEARCH DESIGN .........................................................................................19

3.5

TARGET POPULATIONS ..................................................................................20

3.6

MEASUREMENT ...............................................................................................21
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3.7

DATA COLLECTION METHODS ....................................................................22

3.8

DATA ANALYSIS AND HYPOTHESIS TESTING .........................................23

3.8.1

DESCRIPTIVE STATISTICS ......................................................................24

3.8.2

NORMALITY TEST .....................................................................................24

3.8.3

HYPOTHESIS TEST ....................................................................................25

3.9

CHAPTER SUMMARY ......................................................................................26

CHAPTER 4 ..................................................................................................................... 27
4.1

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

4.2

COMPARISON OF EY+ROIC PORTFOLIO AND FBMKLCI ........................27

4.3

COMPARISON OF EY+ROIC PORTFOLIO AND FBMKLCI ........................31

CHAPTER 5 ..................................................................................................................... 38
5.1

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

5.2

SUMMARY OF FINDINGS ...............................................................................38

5.3

LIMITATION OF STUDY ..................................................................................40

5.4

RECOMMENDATION FOR FURTHER STUDIES ..........................................41

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

LIST OF FIGURES

Figure 3.1: The Conceptual Framework .......................................................................... 18


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

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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

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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

In 1949, Benjamin Graham has introduced a structured approached to investing


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
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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

CONSTRUCTION OF THE THESIS

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.

An extensive comparison of the performance of popular stock screening strategies


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

JOEL GREENBLATT THE LITTLE BOOK THAT BEATS THE

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

THE MAGIC FORMULA STOCK SCREENER CRITERIA

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)

FBMKLCI (Average Market


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

DATA COLLECTION METHODS

A portfolio will be constructed according to the rules of the formula established by


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

DATA ANALYSIS AND HYPOTHESIS TESTING

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

The descriptive statistics functions to provide an initial description of the sample in a


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

Normality test is done using the Anderson-Darling Normality test to generate a


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)

One sample t-statistics=

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

COMPARISON OF EY+ROIC PORTFOLIO AND FBMKLCI

Table 4.2: Descriptive Statistics of EY+ROIC Portfolio


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

95% C onfidence Interv al for M ean


1035.2

1796.3

95% C onfidence Interv al for M edian


826.9

1871.9

95% C onfidence Interv al for S tD ev


9 5 % C onfidence Inter vals

503.1

1083.7

Mean
Median
1000

1250

1500

1750

2000

28

Figure 4.2: Normality Test of FBMKLCI


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

95% C onfidence Interv al for M ean


933.9

1379.8

95% C onfidence Interv al for M edian


806.0

1437.5

95% C onfidence Interv al for S tD ev


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

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


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

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


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

COMPARISON OF EY+ROIC PORTFOLIO AND FBMKLCI

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.

Figure 4.3: Normality Test of EY Portfolio


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

95% C onfidence Interv al for M ean


985.7

1896.9

95% C onfidence Interv al for M edian


871.9

1711.3

95% C onfidence Interv al for S tD ev


9 5 % C onfidence Inter vals

602.4

1297.6

Mean
Median
1000

1200

1400

1600

1800

2000

32

Figure 4.4: Normality Test of ROIC Portfolio


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

95% C onfidence Interv al for M ean


1253.6

2564.8

95% C onfidence Interv al for M edian


972.7

2539.2

95% C onfidence Interv al for S tDev


9 5 % C onfidence Inter vals

866.7

1867.1

Mean
Median
1000

1250

1500

1750

2000

2250

2500

Figure 4.5: Normality Test of FBMKLCI


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

95% C onfidence Interv al for M ean


933.9

1379.8

95% C onfidence Interv al for M edian


806.0

1437.5

95% C onfidence Interv al for S tDev


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).

Table 4.5: Comparison of EY Portfolio with FBMKLCI Portfolio


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

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


N
15

Mean
1441

Test of mu = 1156.8 vs not = 1156.8


StDev
SE Mean
95% CI
823
212
(985, 1897)

T
1.34

P
0.202

35

Table 4.7: Comparison of ROIC Portfolio with FBMKLCI Portfolio


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

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


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

There is an emerging growth of interest towards value investing in detecting stocks


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

RECOMMENDATION FOR FURTHER STUDIES

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

1) Display Descriptive Analysis


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