Does Magic Formula Investing Work in Hong

Kong Stock Market?

Si Fu and Chun Xia
The University of Hong Kong

ABSTRACT
We test the Magic Formula strategy of Greenblatt (2006) in Hong Kong stock market.
We rank companies by their return on capital and earnings yield, and then to buy the
stocks with the best combined rank. We nd that the top 10% of stocks with the best
combined rank have an equal-weighted average portfolio return of 2.53% per month
while the bottom 10% stocks has only 1.30% average portfolio return per month. We
construct six portfolios as the intersections of two portfolios formed on the rm size and
three portfolios formed on the combined ranking computed from the magic formula.
We show that, for both large and small stock groups, the portfolios of stocks with high
rankings from the magic formula outperform the portfolios with low rankings. For the
large stocks, the portfolio with high rankings has 14.61% higher annualized return than
that with low rankings. For the small stocks, the portfolio return of high ranking stocks
is 6.04% higher than that of the low ranking stocks. The time-series regression shows
that the risk factor constructed from the ranking calculated from the magic formula
has explanatory power to the variation of stock returns in addition to the Fama-French
three factors.

It is well known that the majority of ideas in nance were either invented or developed
in academia, before they crossed over into practice. To name a few, the portfolio theory
pioneered by Markowitz (1952), the option pricing theory by Black and Sholes (1973), and
Merton (1973), the asset allocation model of Black and Litterman (1992), the low volatility investing of Haugen and Heins (1975) and Ang, Hodrick, Xing and Zhang (2006) have
witnessed their broad and extensive applications in the investment industry. It is also true
some famous investment strategies were rst initiated or discovered by practitioners and
then later examined, rened, and extended by nance researchers. Notable examples include the value and growth investing, the momentum strategies. A recent specic example
is the all-weather strategypopularized by Ray Dalio, the founder of a leading hedge fund
Bridgewater Associates. It is also known as the risk-parity investing because it aims at
creating a portfolio where each included asset class contributes equally to the overall risk of
the portfolio.1 This strategy has inspired academic studies such as Qian (2005), Martellini
(2008), and Choueifaty and Coignard (2008) as well as many other funds including AQR
where their research (Hurst, Johnson, and Ooi, 2010, and Asness, Frazzini, and Pedersen,
2012) has further made the idea of this strategy accessible to both professional and individual
investors.
In this chapter we plan to do a similar exercise and choose to exploit the investment idea
behind a strategy called the magic formula, by back-testing its eectiveness using data from
the Hong Kong stock market. This stock-picking strategy is employed by Joel Greenblatt, a
value styled manager of the hedge fund Gotham Capital (with asset under management of
AUM $2.74 billion in 2013) and an adjunct professor at the Columbia University Graduate
School of Business. Greenblatts investment philosophy presented in his book The Little
Book That Beats the Market published in 2006 can be summarized as buying stocks of
good companies that have high returns on capital when theyre traded at bargain prices so
that their earnings yields are high. In other words, the magic formula invests in companies
1

Bridgewater launched the rst investment product based on risk parity called the All Weather fund
in 1996, and the term risk parity was originally coined by Edward Qian in 2005.

through a ranking system. The higher return on capital and higher earnings yield is a
company, the higher the rank this company enjoys. The idea is akin to the famous quote
from Warren Buett: Its far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.
Greenblatt denes the return on capital and earning yield in the following unique way.
Return on Capital = EBIT=Tangible Capital Employed
Earning Yield = EBIT=EnterpriseValue
where EBIT is the operating earnings before interest and tax, tangible capital employed is
the sum of net working capital (NWC) and net xed asset (NFA), and enterprise value (EV)
is the sum of market value of equity (including preferred equity) and net interest bearing
debt. We will explain why Greenblatt uses these two denitions instead of more common
measures in the next section.
When investing in the stocks traded in the New York Stock Exchange, the magic formula
strategy achieved a compound annual return of 30.8% from 1988 to 2004, while the compound
annual return of S&P 500 was only 12.4% during the same period.2 The numbers become
22.9% and 12.4% respectively when the strategy was applied to the largest 1000 companies
stocks, all of which had a market value over $1 billion. Greenblatt claims these results can be
replicated using a database Point in Timefrom Standard & Poors Compustat that is free
of look-ahead bias and survivorship bias. It is also found that when companies are divided
into 10 equal portfolios based on their rankings and the portfolios were rebalanced each
month, then the compound annual returns from 1988 to 2004 were ranked in a decreasing
manner from the best-ranked portfolio to the worst-ranked one. Alpert (2006) reports that
2

Specically, Greenblatt rank the largest 3,500 stocks on the U.S. stock exchanges from 1 to 3,500 based
on their return on capital and earnings yield, respectively. The stock with the highest return on capital is
assigned a rank of 1, and the stock with the lowest return on capital receives a rank of 3,500. Similarly, the
stocks are ranked by the earnings yield as well, assigning number 1 to the one with the highest earning yield
and number 3,500 to the one with the lowest. Then, the two rankings are added. The stocks with the small
total ranks have a combination of high return on capital and high earnings yield. Getting excellent rankings
in both categories would be better than being the top-ranked in one category but being the bottom-ranked
in the other under this system. Portfolios are formed based on the total ranking and rebalanced once a year.

Greenblatts hedge fund has averaged over 40% annual returns since the 1980s.
Even though the magic formula investing is well known among investment community, a
robust analysis of its eectiveness is lacking.3 In addition, the value investing professionals
often has a dierent view of risk from academic researchers. They argue that volatility is
not a proper measure for risk because the upside moves of prices should not be deemed
as an increase in risk. They view risk to be the probability of losing money so that they
develop a systematic way to pick up undervalued stocks. We believe it would be interesting
and necessary to examine Greenblatts magic formula strategy through a traditional view of
risk via asset pricing models such as CAPM and Fama-French 3-factor model. Prior to our
research, there are a few studies that back-test the magic formula investing using dierent
data sources in order to judge whether this investing strategy can truly outperform the
market or other risk-adjusted returns. First, Alpert (2006) reports that various replications
of Greenblatts strategy using the U.S. data of the same period show similar results, although
the replicated returns are lower than Greenblatts claims, probably due to dierence in
accounting measures. For instance, ClariFI, a partner rm of Compustat, nds the magic
formula investing can achieve an average return of 28 percent and 17.5 percent using the
largest 3500 and 1000 U.S. stocks, respectively. Second, replication study by Montier and
Lancetti (2006) test the strategy on US, European, UK and Japanese markets between 1993
and 2005 and nd it beat the market (an equally weighted stock index) by 3.6%, 8.8%,
7.3% and 10.8% in the various regions respectively. These studies do not examine the
outperformance of magic formula from a traditional asset pricing model. The only exception
that we are aware of is a study by Persson and Selander (2009), who use stocks data in
the Nordic Region between 1998 and 2008 and nd that the portfolio formed on the magic
formula during 1998-2008 had a compounded annual return of 14.68% compared to 9.28% for
the MSCI Nordic and 4.23% for the S&P 500, respectively. However, they also demonstrate
3

Greenblatts book has become a bestseller since its initial publication. Several websites have been
built for investors to employ the magic formula investing, including www.magicformulainvesting.com and
www.smartmoney.com.

that the excess return was not signicant from zero when testing against the CAPM or Fama
French 3-factor model on the 5% level. To our best knowledge, whether the magic formula
investing is eective in the Hong Kong stock market is yet to be examined.
We analyze the Hong Kong listed rms from 2001 to 2014 with the same approach as
Greenblatt (2006). We nd that, if we invest in the top 10% of the sample stocks with
a combination of high return on capital and high earnings yield, a 2.53% monthly return
can be achieved for the whole sample period. As we separate the stocks in half according
to their market capitalization, we nd the top 30% of the large stocks with high magic
formula measure would earn an annualized return of 20.26% while the bottom 30% with low
magic formula measure would earn only 5.65% annually. Similarly for the small stocks, the
portfolio of stocks with high magic formula measure has 6.04% more return annually than
the portfolio with low magic formula measure.
We compare performance of the portfolios formed on the size and value factors and that
of the portfolios formed following the magic formula, and show that the new factor created
following the magic formula has extra power to explain the stock returns in addition to the
size and value factors. Comparing the estimates of regressions on the constructed FamaFrench three factors with and without the magic formula factor, we nd that the magic
formula measure is statistically signicant in the time-series regressions, and when added,
the adjusted R-square increases about 1%, indicating that it contributes to explain the timeseries variation in the stock returns slightly. As the correlation of MF and the Fama-French
factors are low, we nd that the estimated coe cients of the Fama-French factors do not
change much when we add the magic formula to the regression. The interception term,
known as alpha, is not signicant, and all the factors together explain about 67% of timeseries variation in returns of the whole sample. Besides, we show that the results using the
revised magic formula measure (MF2) are quite similar as we use the original magic formula
measure (MF1). This indicates that whether to include the intangible asset in the calculation
of return on capital does not change the performance of the magic formula dramatically. We

also nd that the explanatory power of the size and value factors for large stocks is weak.
The MF2, however, more signicantly inuences the returns of large stocks.
The Fama-MacBeth regression shows that only the MF1 factor has a signicant and
positive risk premium of 0.19 and the MF2 factor has a positive risk premium of 0.15 at the
1% signicant level. The Fama-French three factors do not bear signicant risk premium. We
examine the estimated risk premium in months and nd that the risk price of MF factor tends
to be positive for most of the months, but the risk prices of the size and value factors are not
always positive. The time-series variation of the estimates is a possible reason for that we do
not observe statistically signicant risk premium of the size and value factors. Comparing
the MF factor and the Fama-French value factor, MF rankings tends to provide a more
comprehensive measure to evaluate both the protability of a rm and its market valuation
together. Hence, the MF rankings seem to be a stricter criterion to distinguish stocks, and
this may be another potential reason for that we observe more stable risk premium estimates
on the MF factor.
Our paper contributes to the literature in two-fold. First, our analysis joins the new trend
that academic seriously examines investment strategies advocated by practitioners who often
emphasize the return outperformance without the risk-adjustment considerations. The test
of magic formula investing through a standard asset pricing exercise helps us to understand
its eectives and risk-return tradeo. Besides, we also observe that existing studies on Hong
Kong stock market are still quite limited (e.g., Chang, Cheng, and Yu, 2007). Our study is
useful to enhance our understanding of the performance of magic formula investing in Hong
Kong. Second, our study also belongs to the new trend that tries to nd new risk factor
beyond the well-known factors such as Fama-French 3-factor, momentum factor (Jegadeesh
and Titman, 1993, Carhart, 1997), liquidity factor (Pastor and Stambaugh, 2003). These
new factors include idiosyncratic volatility (Ang, Hodrick, Xing, and Zhang, 2006), failure
probability (Campbell, Hilscher, and Szilagyi, 2008), asset growth (Cooper, Gulen, and
Schill, 2008), protability (Fama and French, 2006), among others. Our study shows that

the magic formula has return predictability beyond that of Fama-French 3 factor and deserves
more attention.
The rest of this chapter is organized as follows. Section 2 presents Greenblatts justications of using the magic formula. Section 3 explains our data resources and summary
statistics. Sections 4 and 5 present the portfolio performance and risk-return analysis, respectively. Section 6 concludes.

1.

The Ideas Behind the Magic Formula

The magic formula investing is a variant of the well-known value investing which aims at

systematically nding above-average companies that can be bought at below-average prices.

The behavioral argument for its eectiveness can be briey summarized as follows: After
a company releases some bad news or is expected to receive some unfavorable news in the
near future, its stock price could be driven down unfairly in the short term by investors
low sentiments or other behavioral biases. However, over time dierent forces such as smart
investors hunting for bargain opportunities, companies repurchasing their own stocks, and
bidding companies taking over the undervalued company would work together to drive up
the stock prices toward its fair value eventually. Of course, the standard nance argues
that the long-term higher return of such a stock comes from the compensation for its higher
risk. However, Greenblatt believes that magic formula investing provides returns far superior above the market averages, and more signicantly, it achieves those returns on much
lower risk than the overall market. One of the objectives of our paper is to test his claim
in the rigorous asset-pricing framework. Before our formal statistical analysis, we explain
why Greenblatt dene the return on capital and earning yields in a dierent way from the
commonly used ones.

1.1. Return on Capital

Greenblatt denes return on capital by measuring the ratio of the 12 month trailing EBIT
(or operating earnings before interest and taxes) to tangible capital employed. This ratio
is used instead of the more common return on equity (ROE, earnings/equity) or return on
assets (ROA, earnings/assets) for a number of reasons.
EBIT replaces reported earnings because companies operate with dierent levels of debt
and diering tax rates. Using EBIT allows investors to compare the operating earnings of
dierent companies without the distortions resulting from dierences in tax rates and debt
levels. It is therefore possible to compare each companys actual earnings from operations,
i.e., EBIT to the cost of the assets used to produce those earnings, i.e., tangible capital
employed. Moreover, Greenblatt assumes that depreciation and amortization expense are
roughly equal to maintenance capital spending requirements. It is, therefore, assumed that
EBIT is the EBITDA net of maintenance capital expenditures.
Tangible capital employed (the sum of net working capital and net xed assets) replaces
total assets or equity (used in ROA and ROE calculation respectively) in order to nd out the
amount of capital that is actually required to carry out the companys business. Net working
capital is a component because a company has to fund its receivables and inventory (excess
cash not used to operate the business is excluded) but does not have to spend money for its
payables that are eectively an interest-free loan (short-term interest-bearing debt is excluded
from current liabilities). Besides net working capital, a company has to purchase xed assets,
such as real estate, plant, and equipment, to operate its business. The depreciated net cost
of these xed assets plus the net working capital constitute an estimate for tangible capital
employed. Notably, intangible assets are excluded in the calculation because in general,
return on tangible capital alone is a more accurate estimate of a businesss return on capital
going forward. In contrast, the ROE and ROA calculations are often distorted by ignoring
the dierence between reported equity and assets, and tangible equity and assets, on top of
the distortions due to diering tax rates and debt levels.
8

1.2. Earnings Yield

Greenblatt uses the concept of earnings yield in order to nd out how much a business
earns relative to the purchase price of the business. Earnings yield is the ratio of EBIT to
enterprise value (EV), i.e., the sum of market value of equity (including preferred equity)
and net interest-bearing debt. This ratio is used instead of the more common price/earnings
ratio (P/E ratio) or earnings/price ratio (E/P ratio) for a number of reasons.
Enterprise value (EV) of a company is used rather than just the companys total market
capitalization, because EV takes into account both the price paid for an equity stake in a
business and the debt nancing employed by the company to generate operating earnings.
By comparing EBIT to EV, we can calculate the pre-tax operating earnings relative to the
price of equity plus any debt assumed, which allows us to place companies with dierent
levels of debt and dierent tax rates on an equal footing when their earnings yields are
compared. In other words, EBIT/EV is not aected by changes in debt levels and tax rates,
whereas P/E and E/P ratios are.
In this paper, we not only follow Grinblatts method to construct the magic formula,
but also consider an alternative measure of capital employed that includes both tangible
and intangible assets for two reasons. First, existing studies have shown the importance of
intangible asset in understanding stock returns (e.g. Chan, Lakonishock, and Sougiannis
(2001), Li and Liu (2012)). Second, because other replications produce returns lower that
whats reported by Greenblatt (2006), we are interested in other measure of asset employed
in the magic formula.

2.

Data
Our sample includes the listed rms on the Main Board (MB) and Growth Enterprise

Market (GEM) of the Hong Kong Exchange from January 1, 2000 to June 30, 2014. Table 3.1
reports the numbers and the total market capitalization of rms listed on the MB and GEM

at the end of each year during the sample period. On June 30, 2014, there are 1495 rms
listed on the MB with total market capitalization of HK$23780.2 billion, and 194 rms listed
on the GEM with total market capitalization of HK$164.2 billion.4 We collect our sample of
Hong Kong listed rms from Compustat Global database and exclude nancial rms with
SIC number between 6000 and 6999 and utility rms with SIC number between 4000 and
4999. By the end of June 2014, our sample contains 1194 rms which account for about 70%
of the whole market. The total market capitalization of our sample rms is HK$11516.8
billion, about half of the whole market capitalization. The proportion of sample in terms of
the market capitalization is less than that in terms of the number of rms, which is mainly
because the excluded nancial and utility rms tend to have large market capitalization.
We collect monthly closing prices of the listed stocks from Compustat Global Security
Daily dataset and calculate the monthly returns in percentage adjusted for dividends and
stock split as follows, according to the guidance from WRDS:5

Returnt =

PRCCDt =AJEXDIt TRFDt

PRCCDt 1 =AJEXDIt 1 TRFDt

100

where PRCCD_t is the month closing price at the end of month t, AJEXDI_t and
TRFD_t are the adjustment factors in WRDS database. We use the 1-month HIBOR as a
proxy for the risk-free rate, and use monthly returns of the Hang Seng Index as a proxy for
the market return.6
4
The number of listed rms and their total market capitalization data for year 2000 to 2013 are obtained
from the HKEx Fact Books released annually in the website of the Hong Kong Stock Exchange. The data
for 2014Q2 is obtained from the HKEx Securities and Derivatives Markets Quarterly Report.
5
See http://wrds-web.wharton.upenn.edu/wrds/
6
The Hang Seng Index (HSI) is a freeoat-adjusted market capitalization-weighted Hong Kong stock
market index, which is used as the main indicator of the overall market performance in Hong Kong. Now,
it contains 48 large companies representing about 60% of the total capitalization of the Hong Kong Stock
Exchange. We collect the closing price of HSI adjusted for dividends and splits at the end of each month
from January, 2000 to June, 2014. During the sample period, HSI began from 17057.7 and increased to the
20,000 point milestone on December 28, 2006. In less than 10 months, it passed the 30,000 point milestone
on October 18, 2007. Its all-time high, set on October 30, 2007, was 31,958.41 points during trading and
31,638.22 points at closing. From October 30, 2007 to October 27, 2008, the index fell nearly two-thirds
from its all-time peak to 10,676.29 points. But it rebounded to the 20,000 point milestone on 24 July, 2009.
At the end of our sample period, HSI closed at 23,190.72 on June 30, 2014.

10

According to the magic formula introduced by Greenblatt, the return on capital employed
is calculated as EBIT divided by capital employed, which equals to the sum of the net working
capital and the net xed assets.
Return on Capital (ROC) = EBIT=Capital Employed (CE)
= EBIT= (Net Working Capital (NWC) + Net Fixed Assets (NFA))
The earnings yield is calculated as EBIT divided by the enterprise value of rm.
Earnings Yield (EY) = EBIT=Enterprise Value (EV)
Considering the alternative approach to measure the capital employed with intangible asset
included, we calculate an alternative measure of return on capital as the dierence of total
asset and current liability. This alternative measure is denoted as the return on capital
(revised) in the following analysis:
Return on Capital_revised (ROC_revised) = EBIT=Capital Employed_revised (CER)
= EBIT= (Total Asset (TA)

Current Liability (CL))

To calculate the above measures, we collect semi-annual data of earnings before interest and
tax (EBIT), net working capital (NWC), net xed asset (NFA), total asset (TA), current
liability (CL) and enterprise value (EV) from Bloomberg. All the measures are lagged for 6
months to ensure that the data is available and no look-ahead bias is involved.
Fama and French (1993, 1996) are the pioneer studies building up a standard framework
to explore the risk factors in asset pricing. The size and value factors in their studies have
strong and robust explanation power to the stock returns. In our study, we rst calculate
the size and value factors with the data of Hong Kong stock markets following Fama and
Frenchs approach, and take these analyses as the benchmark. We compare performance of
the portfolios formed on the size and value factors and that of the portfolios formed following
the magic formula, and examine whether the new factor created following the magic formula
11

has extra power to explain the stock returns in addition to the size and value factors.
We collect the annual data from Compustat to calculate the size and book-to-market
ratio of the rms. All the accounting data in currency other than the Hong Kong Dollar are
transferred using the historical exchange rates provided on the OzForex website.7 The rm
size is calculated as the natural logarithm of the market capitalization in million HKD at
the end of each calendar year. The book-to-market ratio is the book value of equity at the
previous scal year end divided by market value at the end of previous year. The market
value of equity equals to the stock price times common shares outstanding, and the book
value of equity is calculated as the total book value of common equity, plus deferred taxes
and investment tax credit, and minus the book value of preferred stock. When the deferred
taxes and investment tax credit are not available, we use the balance sheet deferred taxes
instead. The redemption value and par value of the preferred stocks are used in order to
estimate the book value of them.8
Table 2 describes the distribution statistics of the returns and the risk measures. Panel A
summarizes the collected whole sample. The average stock return of our sample is 1.54% per
month during the period from January 2000 to June 2014. The return has a value-weighted
mean of 3.07% per month and a standard deviation of 48.55% per month. They are both
higher than the equal-weighted ones as they concentrate on a few very large stocks. The
value-weighted return moves much when some of the large stocks have extraordinary performance. As there are some missing values of the rm fundamentals, we further summarize
a subsample that we will use to form portfolios and calculate the risk factors in Panel B.
This subsample only contains stocks with size, book-to-market ratio and one of the return
on capital measures or the earnings yield measure available. We nd that the sample with
non-missing measures has slightly higher returns, large rm sizes and smaller book-to-market
7

The historical exchange rate data is obtained from the website http://www.ozforex.com.au/forextools/historical-rate-tools/historical-exchange-rates.
8
We
use
the
variable
denitions
of
Frenchs
data
library
as
reference
to
calculate
size
and
book-to-market
ratio
measures.
See
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/variable_denitions.html

12

ratios.
Following Greenblatt, we rank the sample stocks according to ROC, ROC (revised) and
EY, respectively. The stock with the highest value of each measure is ranked number 1, and
the rank number increases as the measure values decrease.
Then, we add the rank on ROC and the rank on EY together to obtain the rst magic
formula measure, denoted as MF1. MF1 is calculated in the exactly same way as Greenblatt
does. As we introduce an alternative return on capital measure denoted as ROC (revised),
we also calculate an alternative magic formula measure MF2 as the sum of ranks on ROC
(revised) and EY. Similarly for MF1 and MF2, a low value indicates a stock has high return
on capital and high earnings yield as the stock is ranked on top.

3.

Portfolio Performance

3.1. Single-sorted Portfolios

Fama and French (1993, 1996) document the size and value eects with the U.S. stock
market evidence. Even with the data up to date, the size and book-to-market ratio are still
being the two major risk factors in explaining the variation in stock returns. The small
rms tend to have higher stock returns than the big rms and the rms with high book-tomarket ratio tend to have higher returns than those with lower book-to-market ratio. The
portfolio analysis used by Fama and French provides a direct way to identify how a factor
may inuence the investment performance. Hence, we follow Fama and Frenchs approach
in our analysis. First, we analyze whether the size and value eects present in the Hong
Kong stock markets as well. Then, we examine whether the new risk factors we construct
following the magic formula contributes to explaining the cross-sectional variations of the
stock performance.
We construct 10 size portfolios according to the decile breakpoints of the natural logarithm of the market capitalization. Decile 1 contains the bottom 10% of stocks with smallest
13

rm size and Decile 10 contains the top 10% of stocks with largest rm size. Panel A of Table
3.3 summarizes the equal-weighted averages of the 10 size portfolios. For the Hong Kong
listed stocks, we also observe the size eect as average portfolio return tends to decrease as
the rm size increases, except that the last portfolio of the largest stocks has slightly higher
return. On average, Decile 1 has a monthly return of 3.2% while that for Decile 10 is about
1.65% per month. Panel A of Table 3.4 summarizes the portfolios weighted by the market
capitalization of rms. The value-weighted portfolio returns have even larger dispersion. As
the rm size increase, the portfolio return tends to decrease as well.
With the stocks having positive book-to-market ratios, we apply similar portfolio analysis
separating the sample into 10 decile portfolios. Decile 1 refers to the stock portfolio with
lowest B/M ratio and Decile 10 is the portfolio with highest B/M ratio. We nd that
the equal-weighted average of portfolio returns are monotonically increasing with the B/M
ratios, except for the top two portfolios with returns slightly lower returns than the 3rd
top portfolio, shown in Panel B of Table 3. Regarding the value-weighted portfolio returns,
the top 5 portfolios have large returns than the bottom 5 portfolios, though they are not
monotonically increasing with the B/M ratio. Panel B of Table 3.4 shows that the top 5
portfolios have about 6% monthly average value-weighted portfolio returns, while the bottom
5 portfolios have about 2% on average.
According to Greenblatt, the magic formula evaluates stocks based on their returns on
capital combining with their earnings yields. High return on capital is proxy for that the rm
have strong protability, and high earnings yield is used as an indicator showing that theyre
traded at bargain prices. In our analysis, we rst examine the factors separately by forming
portfolios according to one of measures, ROC, ROC (revised) or EY. We restrict our sample
with positive ROC, ROC (revised) and EY measures, and calculate the equal-weighted and
value-weighted average returns of 10 decile portfolios shown in Table 3.3 and Table 3.4. We
nd that the equal-weighted average returns of the 10 portfolios formed on ROC and ROC
(revised) do not demonstrate a monotonic pattern as those of size or B/M ratio portfolios,

14

although the top decile portfolio formed with the ROC measure has an average return about
0.5% higher than the bottom decile per month. The average value-weighted ROC and ROC
(revised) portfolio returns do not monotonically increase with the return on capital measures,
neither. The portfolio with high EY tends to have higher returns than the portfolio with low
EY. The top decile portfolios formed with the EY measure has a 1% higher average return
compared with the bottom decile.
We add the rank on ROC and the rank on EY together to obtain the rst magic formula
measure MF1, and alternatively, use rank on ROC (revised) instead of ROC to calculate
MF2. 10 decile portfolios are formed on MF1 and MF2 each. As the portfolios with smaller
ranks calculated from the magic formula refers to rms with high return on capital and
with bargain prices, we expect that the portfolio returns should decline from Decile 1 to
Decile 10 if the magic formula claim is valid. Our evidence in the last two panels of Table
3.3 and Table 3.4 support the argument. We nd that the top 2 decile portfolios formed
on MF1 and MF2 have the largest portfolios returns and the bottom 2 portfolios have the
smallest average returns. However, the average returns of portfolios in the middle do not
monotonically decrease.
Figure 1 and Figure 2 show the equal-weighted and value-weighted average returns of
portfolios formed on the measures together. First, we conrm the eect of rm size and
book-to-market ratio as risk measures on the Hong Kong stock markets. Second, considering
return on capital or earnings yield alone, we nd that the returns on capital of the rms do
not lead to much of the dierence in returns, while rms with high earnings yield tends to
have higher returns.

3.2. Double-sorted Portfolios

To analyze the possible dierent inuence of factors in large and small rms, we construct
six double-sorted portfolios with the intersections of 2 portfolios formed on size and 3 portfolios on one of the other factors. We use the median of the size measure as the breakpoints
15

to separate the stocks into big and small stock groups. We use the 30th and 70th percentile
values of the other measures as the breakpoints to categorize stocks into the high, medium
and low portfolios of the specic measure. The analysis of double-sorted portfolio enables
us to observe how the factors inuence the big and small stocks, respectively.
Table 5 reports the equal-weighted means of returns, standard deviations and Sharpe
ratios of the double-sorted portfolios. The returns are annualized and reported in percentage
value. We nd that the B/M ratio inuences more on the returns of large rms. The
dierence of returns between the high and low B/M portfolios is 24.78% annually for large
rms while it is 10.83% for small rms.
Regarding the small stocks, we nd that they are more sensitive to the ROC and ROC
(revised) measures. The geometric mean of the small-high portfolio returns sorted on size
and ROC is 31.98% per year and that of the small-low portfolio is 20.84%. Similarly for ROC
(revised), the mean of small-high portfolio returns is 34.84% while the small-low portfolio
has an average return of 18.78%. The dierence between the high and low portfolios on ROC
and ROC (revised) are both over 10% per year for the small stocks. However, the return of
the large-high portfolio on size and ROC minus that of the large-low portfolio is 5.55% only,
and the return of the large-high portfolio on size and ROC (revised) is even lower than that
of the large-low portfolio.
When we consider ROC and EY together as the magic formula, we nd that the both
the large and small stocks with high MF1 have signicantly higher return than the portfolios
with low MF1. For the large stock group, the dierence of the high and low portfolios is
14.61% annually, and for the small stock group, the dierence is 6.04%. As we consider ROC
or EY alone, they tend to explain more variation in returns of small stocks. But when we
consider them together, it distinguishes the returns more on large stocks. We also examine
the MF2 computed using the ROC (revised) and nd that the inuence of MF2 on large
stocks is weaker than the original MF1 measure.
In Table 6, we summarized the value-weighted returns of the double-sorted portfolios.

16

The stock returns are weighted by the natural logarithm of market capitalization and we
nd similar results as the equal-weighted ones.9 Panel C of Table 6 summarizes the standard
deviations of the portfolios and Panel D reports the Sharpe ratios of the portfolios calculated
as the geometric means of portfolio returns divided by the standard deviations. The standard
deviations of portfolios are similar and hence the Sharpe ratio is high when the average return
is large.

4.

Regressions on Risk Factors

4.1. Construct Risk Factors

We construct 2?? portfolios with median breakpoints of size, B/M ratio and one of the
magic formula measures and separate the stocks into 8 portfolios labelled with three letters.
A stock with label BHLmeans it is a big stock with high B/M ratio and low magic formula
measure. Then, we calculate the risk factors as follows.
SM B = 1=4

(RSHH + RSHL + RSLH + RSLL )

1=4

(RBHH + RBHL + RBLH + RBLL )

BM _HM L = 1=4

(RSHH + RSHL + RBHH + RBHL )

1=4

(RSLH + RSLL + RBLH + RBLL )

M F _HM L = 1=4

(RSHH + RSLH + RBHH + RBLH )

1=4

(RSHL + RSLL + RBHL + RBLL )

To construct the risk factors with each magic formula measures, including ROC, ROC
(revised), EY, MF1 calculated from rankings of ROC and EY, and MF2 calculated from
rankings of ROC (revised) and EY, we restrict our sample to have positive rm size, B/M
ratio and the target magic formula measure to ensure that every stock is allocated into one of
the portfolios. Hence, we have a distinct subsample to construct each set of the risk factors,
but the subsamples have great overlap.
Table 3.7 shows the summary statistics and the correlations of each set of risk factors
9

We weight the returns using the natural logarithm of market capitalization to avoid the portfolio returns
to be dominated by the performance of a few very large rms in the portfolio.

17

in one panel. The value factor has a very signicant return which is over 1% on average.
Besides, the factors of ROC and ROC (revised) also have statistically signicant returns but
smaller in magnitude. The correlations among the factors are low.

4.2. Time-Series Regressions

In this subsection, we aim to analyze how much time-series variations in stock returns can
be explained by the risk factors of the market, size and value, additionally with the factor
constructed from the magic formula. First, we run time-series regressions of the valueweighted portfolio return of our whole sample on the proposed risk factors. Table 3.8 shows
the regression results. Panel A compares the estimates of regressions on the constructed
Fama-French three factors with and without the magic formula factor MF1. We nd that
the magic formula measure is statistically signicant, and when added, the adjusted R-square
increases about 1% as it contributes to explain the time-series variation in the stock returns
slightly. As the correlation of magic formula factors and the Fama-French factors are low,
we nd that the estimated coe cients of the Fama-French factors do not change much when
we add the magic formula to the regression. The interception term, known as alpha, is not
signicant, and all the factors together explain about 67% of time-series variation in returns
of the whole sample. Panel B reports the estimates of regressions on the Fama-French three
factors and the MF2, and we nd the results are quite similar as we use MF1. This indicates
that whether to include the intangible asset in the calculation of return on capital does not
change the performance of the magic formula dramatically.
In Table 3.9, we separate the sample stocks into 5 quantile portfolios on size, and take the
value-weighted portfolio returns as the dependent variables for the regression. Size Portfolio
1 refers to the group of the smallest 20% stocks and Size Portfolio 5 includes the largest 20%
stocks. First, we nd over 70% of the time-series variation of the portfolio of the largest
stocks can be explained by the factors, while for the smaller stock groups, the explanatory
power is weaker. Second, the market and the magic formula factors are signicant in all the
18

size portfolio regressions, shown in Panel A of the table. But the size and the value factor
are not signicant for the largest stock portfolio and the alpha is signicant. From Panel B,
we also nd that the explanatory power of the size and value factors for large stocks is weak.
MF2, however, more signicantly inuences the returns of large stocks.

4.3. Fama-MacBeth Regressions

We estimate of the risk premium of the Fama-French three factors and the magic formula
factor we newly construct with the Fama-MacBeth regressions. We rst regress the individual
stock returns in excess of the risk-free rate on the factors to estimate the beta of each asset
for the factor. We run the time-series regressions with the rolling window of 12 months.
In the second stage, we run cross-sectional regressions of the stock excess returns on the
estimated betas and estimate the risk premium for each factor in each month. Then, we
calculate the time-series average of the risk premium on each factor for the whole sample
period and report the estimation results in Table 3.10. The average is calculated based on
estimates of 144 months. We use the Newey-West standard errors to correct for the potential
autocorrelations. Based on the results, we nd that only the MF1 factor has a signicant and
positive risk premium of 0.19, and the MF2 factor has a positive risk premium of 0.15 at the
1% signicant level. However, the risk premiums of the Fama-French three factors are not
signicantly dierent from zero. We examine the estimated risk premium in months and nd
that the risk price of magic formula factors tends to be positive for most of the months, but
the risk prices of the size and value factors are not always positive. The time-series variation
of the estimates is a possible reason for that we do not observe statistically signicant risk
premium of the size and value factors. Comparing the magic formula factors and the FamaFrench value factor, rankings calculated from the magic formula tend to provide a more
comprehensive measure to evaluate both the protability of a rm and its market valuation
together. Hence, the magic formula seems to be a stricter criterion to select stocks. This
may be another reason for that we observe more stable risk premium estimates on the magic
19

formula factors.
During our sample period, the Hong Kong stock market experienced a quite important
structural change. Since the year of 2005 to 2006, there are some large stocks from Mainland
China listed on the Hong Kong stock exchange. The total market capitalization increase
dramatically. Besides, in 2007, the Exchange adopted an electronic system to publish the
announcements of listed rms. For our sample, we observe that more data is available since
the year of 2007. Hence, to make a robustness test of our analysis, we estimate the risk
premium again using the sample period from July 2007 to June 2014. The results are shown
in Table 3.11. We nd similar estimated risk premium of the MF1 and MF2 factors. MF1
has a signicant and positive risk premium of 0.16 at the 1% signicant level, and MF2 has
a positive risk premium of 0.11 signicant at 5% level. The Fama-French three factors still
do not bear signicant risk premium.

5.

Conclusion
Motivated by the recent trend that academic researchers start to examine the investment

strategies either pioneered or advocated by practitioners in asset management industry, we

investigate the eectiveness of the magic formula investing on Hong Kong stock market in
the standard asset pricing framework. We nd that, if we invest in the top 10% of the sample
stocks with a combination of high return on capital and high earnings yield, a 2.53% monthly
return can be achieved for the sample period. Comparatively, the portfolio of the bottom 10%
stocks with low return on capital and low earnings yield has an average monthly return of
1.30% per month. As we separate the stocks in half according to their market capitalization,
we nd the top 30% of the large stocks with high magic formula rankings would earn an
annualized return of 20.26% while the bottom 30% with low magic formula rankings would
earn only 5.65% annually. Similarly for the small stocks, the portfolio of stocks with high
magic formula rankings has 6.04% more return annually than the portfolio with low magic

20

formula rankings.
We examine whether the new factor created following the magic formula has extra power
to explain the time-series variation in stock returns in addition to the Fama-French three
factors. We nd that the adjusted R-squares of the regressions increase about 1% as the
factor MF1 is added to the Fama-French three factor model, and the coe cient estimates of
MF1 is signicant dierent from zero. The Fama-MacBeth regressions show that MF1 has
a signicant and positive risk premium of 0.19.
Our next research agenda is to rene the magic formula investing and extend our work
to mainland Chinese stock market. By 2013, over 80% of the total market capitalization
of the Hong Kong Stock Exchange consists of companies from mainland China. It is well
known that on the one hand, the Chinese economy has performed extraordinarily well in
the past thirty years with an annual growth rate of over 9 percent, one the other hand,
the performance of the Chinese stock market has been notoriously disappointing, especially
compared to the growth of GDP. The question we want to address in our future research
is whether the magic formula strategy can be applied to the Chinese stock market, given
its eectiveness in the Hong Kong stock market. If the answer is yes, we should ask why
investors missed the opportunity. If the answer is no, we should nd out what unique features
of Chinese stock market lie behind the scene.

21

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23

Table 2. Summary Statistics of Returns and Fundamental Measure

This table reports the summary statistics of the sample. Panel A describes the whole sample with all available data, and Panel B summarizes the statistics of the sample stocks
we use for further analysis which have the return, the size proxy, the book-to-market ratio and one of the return on capital and earnings yield measures available. The returns
are weighted equally and weighted by the market capitalization of each stock. The market beta of each stock is estimated using the stock excess returns and the market return
in excess of the risk-free rate for the whole sample period. Size is calculated as the natural logarithm of market capitalization. Book-to-market ratio is calculated as the book
value of equity at the previous fiscal yearend divided by market value at the end of previous year. Return on capital is calculated as EBIT divided by capital employed, which
equals to the sum of the net working capital and the net fixed assets. A revised version of return on capital is calculated using the difference of total asset and current liability
as the proxy for capital employed. Earnings yields are calculated as EBIT divided by the enterprise value of firm.

Panel A: Whole sample

Panel B: Sample with Non-missing Measures

Mean

Std

Min

Max

Mean

Std

Min

Max

Equal-weighted Return (%)

134601

1.54

20.90

-99.94

110.53

78109

1.71

19.65

-96.58

110.53

Value-weighted Return (%)

134568

3.07

48.55

-99.94

110.53

78109

3.33

56.22

-96.58

110.53

Beta

135585

0.94

0.44

-1.11

3.35

78109

0.95

0.41

-0.91

2.92

Size

135495

6.71

1.79

-2.16

13.96

78109

7.03

1.76

1.48

13.96

Book-to-Market Ratio

125642

1.76

18.36

-347.70

1814.32

78109

1.37

2.11

-32.03

71.18

Return on Capital

73947

0.04

0.15

-0.71

0.54

68023

0.04

0.15

-0.71

0.54

Return on Capital (Revised)

83679

0.03

0.11

-0.60

0.36

76736

0.03

0.11

-0.60

0.36

Earnings Yields

81614

0.03

0.12

-0.44

0.68

75766

0.03

0.12

-0.44

0.68

Table 3. Decile Portfolios with Equal-weighted Summary Statistics

This table reports the equal-weighted means of monthly returns, market betas and risk proxies of the decile portfolios formed by each measure. The first column summarizes
the subsample which has non-missing values of the measure used to form portfolios. For each measure, we exclude the stocks with missing or negative values, then separate
the remaining stocks into 10 decile portfolios according to the decile breakpoints. Decile 1 includes the stocks with lowest values of the risk measure and Decile 10 includes
the stocks with highest values of the risk measure. We report the equal-weighted means of the monthly stock returns, market betas estimated using the whole sample period,
firm sizes, book-to-market ratios, measures of return on capital employed (ROC and ROC (Revised)) and earnings yields (EY), winsorized at 1% and 99% level to avoid the
influence of the extreme values. The sample period includes 162 months, from January 2001 to June 2014.

All

Decile 1

Decile 2

Decile 3

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.68
0.94
6.48
1.59
0.04
0.03
0.04

3.20
0.85
3.98
2.34
-0.03
-0.04
0.01

2.86
0.87
4.83
2.01
0.02
0.00
0.03

2.03
0.88
5.31
2.04
0.01
0.01
0.04

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.64
0.93
6.51
1.74
0.04
0.03
0.04

0.52
0.92
7.10
0.17
0.03
0.01
0.00

1.00
0.94
7.25
0.39
0.07
0.05
0.02

1.02
0.94
7.11
0.58
0.06
0.05
0.04

Decile 4
Decile 5
Panel A: Size Portfolios
1.51
1.45
0.91
0.92
5.71
6.09
1.87
1.65
0.01
0.03
0.02
0.02
0.04
0.07
Panel B: B/M Ratio Portfolios
1.15
1.60
0.93
0.93
6.87
6.55
0.79
1.03
0.06
0.04
0.05
0.03
0.06
0.05

Decile 6

Decile 7

Decile 8

Decile 9

Decile 10

1.01
0.96
6.51
1.51
0.04
0.03
0.05

0.97
0.96
6.97
1.25
0.05
0.04
0.06

1.15
0.96
7.50
1.20
0.06
0.04
0.05

1.00
1.01
8.25
1.00
0.07
0.06
0.04

1.65
1.04
9.73
1.03
0.11
0.07
0.03

1.92
0.93
6.39
1.31
0.04
0.03
0.05

2.17
0.93
6.25
1.65
0.05
0.04
0.07

2.40
0.92
6.14
2.13
0.03
0.03
0.06

2.36
0.91
5.84
2.92
0.02
0.02
0.05

2.27
0.98
5.64
6.46
0.01
0.01
0.04

Table 3. Decile Portfolios with Equal-weighted Summary Statistics (Continued)

All

Decile 1

Decile 2

Decile 3

Decile 4
Decile 5
Decile 6
Panel C: ROC Portfolios
1.84
2.11
1.61
0.92
0.94
0.95
7.00
7.16
7.14
1.65
1.39
1.28
0.05
0.07
0.08
0.05
0.06
0.07
0.06
0.08
0.08
Panel D: ROC (Revised) Portfolios
1.56
2.12
1.83
0.94
0.91
0.96
7.10
7.06
7.16
1.99
1.48
1.28
0.06
0.07
0.09
0.04
0.05
0.07
0.06
0.07
0.08

Decile 7

Decile 8

Decile 9

Decile 10

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.81
0.93
7.06
1.46
0.10
0.08
0.08

1.63
0.91
6.38
2.31
0.01
0.01
0.02

1.85
0.91
6.65
2.09
0.02
0.02
0.04

1.45
0.93
6.73
1.82
0.04
0.03
0.06

1.77
0.91
7.41
1.00
0.10
0.09
0.08

2.02
0.92
7.47
0.97
0.13
0.11
0.09

1.85
0.93
7.55
0.83
0.17
0.14
0.11

2.01
0.95
7.28
1.03
0.32
0.21
0.15

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.93
0.93
7.11
1.50
0.10
0.08
0.07

1.54
0.91
6.57
2.13
0.01
0.01
0.02

1.91
0.91
6.93
2.21
0.03
0.02
0.03

2.06
0.90
7.00
1.95
0.04
0.03
0.05

1.80
0.95
7.29
1.08
0.10
0.08
0.08

2.18
0.92
7.44
0.94
0.13
0.10
0.08

1.90
0.93
7.47
0.89
0.17
0.14
0.11

2.38
0.95
7.19
0.64
0.28
0.23
0.15

Table 3. Decile Portfolios with Equal-weighted Summary Statistics (Continued)

All

Decile 1

Decile 2

Decile 3

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.96
0.93
7.11
1.45
0.10
0.07
0.08

1.34
0.90
7.67
1.09
0.06
0.04
0.00

1.69
0.94
7.11
1.57
0.06
0.04
0.01

2.18
0.93
7.61
1.40
0.07
0.05
0.02

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.79
0.92
7.09
1.42
0.10
0.08
0.08

2.53
0.90
6.44
1.40
0.24
0.18
0.23

2.36
0.94
7.00
1.13
0.15
0.12
0.13

1.69
0.93
7.11
1.20
0.12
0.10
0.10

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

1.92
0.93
7.14
1.47
0.10
0.07
0.07

2.91
0.89
6.38
1.19
0.23
0.18
0.23

2.15
0.95
6.99
1.14
0.15
0.12
0.12

2.06
0.93
7.09
1.29
0.12
0.10
0.09

Decile 4
Decile 5
Panel E: EY Portfolios
1.85
2.00
0.94
0.97
7.79
7.39
1.55
1.36
0.08
0.09
0.06
0.07
0.03
0.04
Panel F: MF1 Portfolios
1.45
1.51
0.92
0.92
7.26
7.28
1.20
1.39
0.11
0.09
0.09
0.08
0.08
0.07
Panel G: MF2 Portfolios
1.37
1.90
0.93
0.93
7.23
7.23
1.25
1.43
0.10
0.09
0.08
0.08
0.08
0.06

Decile 6

Decile 7

Decile 8

Decile 9

Decile 10

1.74
0.94
7.14
1.31
0.10
0.08
0.05

1.77
0.93
7.00
1.36
0.11
0.09
0.07

2.30
0.94
6.79
1.51
0.11
0.09
0.09

2.32
0.89
6.50
1.51
0.14
0.11
0.15

2.62
0.89
6.07
1.81
0.17
0.13
0.33

2.05
0.92
7.43
1.29
0.09
0.07
0.05

1.99
0.91
7.35
1.51
0.07
0.05
0.04

2.00
0.94
7.38
1.46
0.05
0.04
0.03

1.09
0.94
6.96
1.78
0.03
0.02
0.02

1.30
0.93
6.70
1.93
0.01
0.01
0.01

1.72
0.94
7.30
1.37
0.08
0.07
0.04

1.93
0.93
7.57
1.75
0.07
0.05
0.03

2.16
0.89
7.49
1.67
0.05
0.04
0.03

1.84
0.94
7.23
1.84
0.04
0.02
0.02

1.10
0.93
6.81
1.77
0.02
0.01
0.01

Table 4. Decile Portfolios with Value-weighted Summary Statistics

The monthly portfolio returns and risk measure are calculated as the means weighted by the market capitalization of each stock. The first column summarizes the subsample
which has non-missing and non-negative values of the risk measure used to form portfolios. The samples are separated into 10 portfolios according to the decile breakpoints
of each risk measure. The measures and the market capitalization used as the weights are both winsorized at 1% and 99% level to avoid the influence of the extreme values.

All

Decile_1

Decile_2

Decile_3

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

4.11
1.00
9.52
1.40
0.10
0.07
0.03

8.39
0.91
4.06
2.97
-0.03
-0.03
0.02

6.32
0.90
4.85
1.84
0.03
0.01
0.04

6.92
0.90
5.33
1.96
0.01
0.01
0.04

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

4.37
0.99
9.50
1.42
0.10
0.07
0.03

2.01
0.95
10.01
0.16
0.19
0.14
0.02

1.99
1.01
9.44
0.39
0.12
0.08
0.03

1.92
1.04
9.10
0.57
0.08
0.06
0.03

Decile_4
Decile_5
Decile_6
Panel A: Size Portfolios
4.71
4.13
3.50
0.94
0.93
0.97
5.72
6.10
6.53
1.94
1.63
1.59
0.02
0.05
0.04
0.03
0.03
0.03
0.04
0.07
0.06
Panel B: B/M Ratio Portfolios
2.27
2.50
6.15
1.03
1.05
1.07
8.81
8.46
8.83
0.78
1.02
1.30
0.08
0.06
0.06
0.06
0.04
0.04
0.05
0.04
0.05

Decile_7

Decile_8

Decile_9

Decile_10

3.06
0.98
6.99
1.33
0.07
0.05
0.07

3.11
0.98
7.53
1.29
0.07
0.05
0.05

2.55
1.00
8.31
1.03
0.09
0.07
0.04

4.36
1.00
10.40
1.43
0.12
0.08
0.03

5.29
1.06
8.66
1.68
0.05
0.04
0.04

10.76
0.93
9.12
2.13
0.05
0.03
0.04

7.51
0.93
8.73
2.94
0.04
0.03
0.05

3.08
0.99
9.66
6.28
0.03
0.03
0.03

Table 4. Decile Portfolios with Value-weighted Summary Statistics (Continued)

All

Decile 1

Decile 2

Decile 3

Decile 4

Decile 5

Decile 6

Decile 7

Decile 8

Decile 9

Decile 10

2.01
1.01
8.90
0.81
0.08
0.07
0.04

2.14
0.98
9.25
0.74
0.10
0.08
0.05

2.83
1.02
9.39
0.63
0.13
0.10
0.05

2.18
1.00
9.65
0.49
0.17
0.14
0.05

2.57
1.00
9.61
0.48
0.31
0.20
0.07

2.12
1.05
8.92
0.84
0.09
0.07
0.04

2.75
1.03
9.17
0.68
0.13
0.08
0.04

2.92
0.99
9.44
0.60
0.13
0.10
0.05

2.47
1.01
9.51
0.49
0.17
0.14
0.06

2.61
1.00
9.73
0.29
0.28
0.22
0.05

Panel C: ROC Portfolios

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

2.60
1.03
9.68
0.99
0.12
0.09
0.04

2.91
1.06
8.48
1.52
0.01
0.01
0.01

4.87
1.00
8.93
1.61
0.02
0.02
0.03

2.22
1.14
9.21
1.32
0.04
0.03
0.03

2.28
1.08
9.75
1.90
0.05
0.04
0.04

2.18
1.05
9.27
1.19
0.07
0.06
0.04

Panel D: ROC (Revised) Portfolios

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

4.53
0.99
9.79
1.35
0.12
0.08
0.04

2.45
1.06
8.82
1.39
0.02
0.01
0.01

10.11
0.86
9.79
1.64
0.04
0.02
0.02

10.13
0.88
9.75
1.55
0.06
0.03
0.03

2.15
1.04
10.15
3.11
0.07
0.04
0.03

1.86
0.99
9.34
1.27
0.07
0.05
0.04

Table 4. Decile Portfolios with Value-weighted Summary Statistics (Continued)

All

Decile 1

Decile 2

Decile 3

Decile 4

Decile 5

Decile 6

Decile 7

Decile 8

Decile 9

Decile 10

2.69
1.09
8.72
0.88
0.12
0.10
0.05

2.78
1.10
8.78
0.95
0.14
0.11
0.07

3.38
1.09
8.45
1.09
0.13
0.11
0.09

4.05
0.99
7.77
1.14
0.14
0.12
0.14

4.01
0.96
7.01
1.54
0.19
0.15
0.31

2.24
0.96
9.83
0.55
0.16
0.11
0.02

2.00
0.98
9.78
1.28
0.09
0.07
0.02

2.64
1.04
9.97
1.42
0.06
0.05
0.02

3.23
1.05
9.45
1.28
0.04
0.03
0.02

2.18
1.03
9.12
1.32
0.02
0.01
0.01

1.89
0.95
9.73
0.58
0.14
0.11
0.02

2.14
0.99
10.16
2.48
0.10
0.06
0.02

9.19
0.86
10.03
1.68
0.07
0.04
0.02

8.50
0.91
9.96
1.41
0.06
0.03
0.02

2.05
1.03
9.31
1.13
0.03
0.01
0.01

Panel E: EY Portfolios
Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

4.34
0.99
9.80
1.37
0.12
0.08
0.04

1.62
0.85
10.16
0.49
0.14
0.08
0.00

3.65
1.01
9.51
1.06
0.10
0.06
0.01

9.43
0.92
10.03
1.40
0.10
0.06
0.02

4.03
0.98
10.08
2.09
0.10
0.07
0.03

2.83
1.09
9.49
1.31
0.13
0.09
0.04

Panel F: MF1 Portfolios

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

2.58
1.04
9.69
0.98
0.12
0.09
0.04

3.58
1.02
7.87
1.05
0.22
0.17
0.18

3.15
1.09
8.80
0.77
0.18
0.14
0.09

2.73
1.04
9.16
0.63
0.18
0.14
0.06

2.15
1.01
8.97
0.74
0.15
0.11
0.05

2.18
1.01
9.20
0.72
0.14
0.10
0.04

Panel G: MF2 Portfolios

Return
Beta
Size
B/M Ratio
ROC
ROC (Revised)
EY

4.55
0.98
9.79
1.35
0.12
0.08
0.04

3.86
1.02
7.80
0.97
0.21
0.18
0.18

2.98
1.12
8.88
0.76
0.18
0.15
0.09

3.07
1.03
8.91
0.77
0.17
0.14
0.06

2.26
1.04
9.03
0.68
0.15
0.12
0.05

2.43
1.02
9.25
0.69
0.13
0.10
0.04

Table 5. Equal-weighted Average Returns on Double-sorted Portfolios

The stocks are separated into 6 portfolios by size and one of the other risk measures. We use the median value
of the size measure and the 30th and 70th percentile value of the other factor as the breakpoints. The portfolio
returns of each month are calculated as the equal-weighted average of the stock returns in each portfolio. The
table reports the means and standard deviations of the time-series of portfolio returns in annualized percentage
value. The Sharpe ratios are calculated as the geometric means of returns divided by the standard deviations.

Size

Size

Size

Size

Size

Size

Panel A: Arithmetic Means

B/M Ratio
High
Medium
Large
27.67
16.41
Small
28.04
25.96
ROC
High
Medium
Large
18.19
17.87
Small
32.24
27.95
ROC (Revised)
High
Medium
Large
20.15
16.50
Small
34.20
28.81
EY
High
Medium
Large
26.00
16.97
Small
30.24
29.52
MF1
High
Medium
Large
23.07
16.57
Small
29.12
26.58
MF2
High
Medium
Large
25.50
16.04
Small
31.27
27.89

Low
5.09
20.00
Low
13.54
22.94
Low
23.28
21.41
Low
17.95
26.35
Low
9.68
24.48
Low
20.27
21.98

Size

Size

Size

Size

Size

Size

Panel B: Geometric Means

B/M Ratio
High
Medium
Large
26.08
13.09
Small
26.45
24.12
ROC
High
Medium
Large
15.46
14.64
Small
31.98
26.88
ROC (Revised)
High
Medium
Large
17.71
13.10
Small
34.84
27.78
EY
High
Medium
Large
24.11
14.09
Small
29.74
28.65
MF1
High
Medium
Large
20.26
13.87
Small
28.50
24.89
MF2
High
Medium
Large
23.34
12.96
Small
31.21
26.32

Low
1.30
15.62
Low
9.91
20.84
Low
21.57
18.78
Low
15.32
24.69
Low
5.65
22.46
Low
18.05
19.66

Table 5. Equal-weighted Average Returns on Double-sorted Portfolios (Continued)

Panel C: Standard Deviations

Panel D: Sharpe Ratios

BM Ratio

Size

BM Ratio

High

Medium

Low

Large

29.25

28.26

27.41

Small

29.81

29.32

33.46

High

Medium

Low

Large

27.12

28.63

28.51

Small

28.98

28.10

28.09

Size

High

Medium

Low

Large

0.89

0.46

0.05

Small

0.89

0.82

0.47

High

Medium

Low

Large

0.57

0.51

0.35

Small

1.10

0.96

0.74

ROC

Size

Size

Large
Small

High
27.21
28.27

Size

Large
Small

High
28.83
27.97

Large
Small

High
29.88
27.53

Large
Small

High
29.39
27.63

Size

Size

ROC (Revised)
Medium
28.52
28.53
EY
Medium
27.11
28.84
MF1
Medium
26.23
28.90
MF2
Medium
27.31
29.45

ROC

Low
26.94
28.92
Low
26.77
28.99
Low
28.87
28.84
Low
26.74
28.34

Size

Size

Large
Small

High
0.65
1.23

Size

Large
Small

High
0.84
1.06

Large
Small

High
0.68
1.04

Large
Small

High
0.79
1.13

Size

Size

ROC (Revised)
Medium
0.46
0.97
EY
Medium
0.52
0.99
MF1
Medium
0.53
0.86
MF2
Medium
0.47
0.89

Low
0.80
0.65
Low
0.57
0.85
Low
0.20
0.78
Low
0.68
0.69

Table 6. Value-weighted Average Returns on Double-sorted Portfolios

The stocks are separated into 6 portfolios by size and one of the other risk measures. We use the median value
of the size measure and the 30th and 70th percentile value of the other factor as the breakpoints. The portfolio
returns of each month are calculated as the value-weighted average of the stock returns in each portfolio, using
the natural logarithm of market capitalization as the weight. The table reports the means and standard deviations
of the time-series of portfolio returns in annualized percentage value. The Sharpe ratios are calculated as the
geometric means of returns divided by the standard deviations.

Panel A: Arithmetic Means of Portfolio Returns

Panel B: Geometric Means of Portfolio Returns

BM Ratio

Size

BM Ratio

High

Medium

Low

Large

29.42

16.70

5.79

Small

26.93

24.33

18.42

Size

High

Medium

Low

Large

28.47

13.41

2.07

Small

25.14

22.26

13.99

ROC

Size

ROC

High

Medium

Low

Large

18.00

17.17

13.84

Small

30.96

26.98

21.46

Size

High

Medium

Low

Large

15.32

13.86

10.29

Small

30.36

25.66

19.22

ROC (Revised)

Size

ROC (Revised)

High

Medium

Low

Large

19.87

16.00

25.63

Small

33.13

27.77

19.65

Size

High

Medium

Low

Large

17.44

12.56

24.56

Small

33.41

26.50

16.90

EY

Size

EY

High

Medium

Low

Large

25.81

17.39

18.77

Small

28.86

28.52

23.89

Size

High

Medium

Low

Large

23.86

14.61

16.34

Small

28.02

27.41

21.94

MF1

MF1

Size

High

Medium

Low

Large

23.10

16.03

9.96

Small

28.01

25.23

23.03

High

Medium

Low

Large

25.37

15.75

22.00

Small

30.27

26.72

19.85

Size

High

Medium

Low

Large

20.32

13.28

6.04

Small

27.14

23.22

20.89

High

Medium

Low

Large

23.20

12.68

20.22

Small

29.93

24.87

17.38

MF2

Size

MF2

Size

Table 6. Value-weighted Average Returns on Double-sorted Portfolios (Continued)

Panel C: Standard Deviations of Portfolio Returns

Panel D: Sharpe Ratios of Portfolio Returns

BM Ratio

Size

BM Ratio

High

Medium

Low

Large

28.69

28.28

27.19

Small

29.65

28.93

32.91

High

Medium

Low

Large

26.87

28.59

28.34

Small

28.92

28.08

27.69

Size

High

Medium

Low

Large

0.99

0.47

0.08

Small

0.85

0.77

0.43

High

Medium

Low

Large

0.57

0.48

0.36

Small

1.05

0.91

0.69

ROC

Size

Size

Large
Small

High
27.03
28.34

Size

Large
Small

High
28.90
27.91

Large
Small

High
29.80
27.45

Large
Small

High
29.37
27.64

Size

Size

ROC (Revised)
Medium
28.44
28.45
EY
Medium
26.97
28.72
MF1
Medium
26.17
28.92
MF2
Medium
27.15
29.43

ROC

Low
26.44
28.33
Low
26.48
28.22
Low
28.57
28.34
Low
26.30
27.60

Size

Size

Large
Small

Size

Large
Small

Size

Size

Large
Small

Large
Small

ROC (Revised)
High
Medium
0.65
0.44
1.18
0.93
EY
High
Medium
0.83
0.54
1.00
0.95
MF1
High
Medium
0.68
0.51
0.99
0.80
MF2
High
Medium
0.79
0.47
1.08
0.85

Low
0.93
0.60
Low
0.62
0.78
Low
0.21
0.74
Low
0.77
0.63

Table 7. Summary Statistics of the Risk Factors

The factors are constructed by the value-weighted returns of the 222 portfolios formed by the size, value and one of measures from the magic formula. For each
measure, we use the median value as the breakpoints and separate the stocks into two categories. We use three letters to denote the categorization of a stock. For example, a
stock in the "BHL" portfolio means it is a big stock with high book-to-market ratio and low magic formula measure. The market factor is calculated as the monthly Hang
Seng Index return minus the 1-month HIBOR rate. Other factors are computed as the average return of the four portfolios with high value of the target measure minus the
average return of the four portfolios with low value of the measure. We report the means, standard deviations and the t-statistics of the monthly factor values. *, **, ** are
used to indicate the 10%, 5% and 1% significant level of the two-tail t-test.

MKT
SMB
BM_HML
ROC_HML

MKT
SMB
BM_HML
ROC_R_HML

MKT
SMB
BM_HML
EY_HML

Panel A Subsample 1 of stocks with positive size, book-to-market ratio and return on capital measures
Summary Statistics
Correlations
Mean
Std
t-value
sig.
MKT
SMB
BM_HML
0.44
6.14
0.90
1.00
-0.34
0.18
0.46
3.86
1.47
-0.34
1.00
-0.17
1.17
2.53
5.76
***
0.18
-0.17
1.00
0.51
2.03
3.14
***
0.10
-0.18
0.20
Panel B Subsample 2 of stocks with positive size, book-to-market ratio and return on capital (revised) measures
Summary Statistics
Correlations
Mean
Std
t-value
sig.
MKT
SMB
BM_HML
0.44
6.14
0.90
1.00
0.02
-0.26
0.17
4.36
0.48
0.02
1.00
-0.42
1.44
3.33
5.41
***
-0.26
-0.42
1.00
0.49
3.20
1.92
*
-0.29
-0.49
0.61
Panel C Subsample 3 of stocks with positive size, book-to-market ratio and earning yields measures
Summary Statistics
Correlations
Mean
Std
t-value
sig.
MKT
SMB
BM_HML
0.44
6.14
0.90
1.00
-0.24
0.12
0.10
3.73
0.32
-0.24
1.00
-0.13
1.28
2.51
6.35
***
0.12
-0.13
1.00
0.00
2.15
0.02
-0.04
0.01
-0.02

ROC_HML
0.10
-0.18
0.20
1.00

ROC_R_HML
-0.29
-0.49
0.61
1.00

EY_HML
-0.04
0.01
-0.02
1.00

Table 7. Summary Statistics of the Risk Factors (Continued)

MKT
SMB
BM_HML
MF1_HML

MKT
SMB
BM_HML
MF2_HML

Panel D Subsample 4 of stocks with positive size, book-to-market ratio and magic formula measures
Summary Statistics
Correlations
Mean
Std
t-value
sig.
MKT
SMB
BM_HML
0.44
6.14
0.90
1.00
-0.32
0.17
0.40
3.82
1.31
-0.32
1.00
-0.20
1.05
2.66
4.92
***
0.17
-0.20
1.00
0.28
2.25
1.54
0.03
-0.07
-0.05
Panel E Subsample 5 of stocks with positive size, book-to-market ratio and magic formula (revised) measures
Summary Statistics
Correlations
Mean
Std
t-value
sig.
MKT
SMB
BM_HML
0.44
6.14
0.90
1.00
-0.30
0.16
0.02
3.76
0.07
-0.30
1.00
-0.09
1.43
2.49
7.17
***
0.16
-0.09
1.00
0.27
2.20
1.52
0.06
-0.08
0.05

MF1_HML
0.03
-0.07
-0.05
1.00

MF2_HML
0.06
-0.08
0.05
1.00

Table 8. Time-series Regressions of Excess Stock Returns on the Risk Factors

The dependent variable of the regression is the value-weighted average monthly return of the sample stocks in excess of the 1-month HIBOR. We report the estimated
coefficients and the Newey-West standard errors. There are 156 months. Panel A reports the estimates of the subsample 1 containing stocks with the factor MF1 which is
calculated following the magic formula from the sum of the rank of ROC and the rank of EY. Panel B shows the estimates of the subsample 2 containing stocks with the
factor MF2 which is computed from the revised magic formula measure using ROC (revised) instead of ROC. *, **, and *** are used to indicate the significance level of
10%, 5% and 1%.

Intercept

MKT

SIZE_SMB

BM_HML

MF_HML

Adj R-Square

Panel A Subsample 1 of stocks with positive size, book-to-market ratio and magic formula measure
Coef
Std Err
Coef
Std Err

0.6441
(0.5050)
0.5101
(0.4933)

1.0466
(0.0977)
1.0447
(0.0915)

***
***

0.3937
(0.1511)
0.4122
(0.1526)

**
***

0.2785
(0.1701)
0.3006
(0.1609)

0.6626
*

0.3753
(0.1127)

***

0.6728

Panel B Subsample 2 of stocks with positive size, book-to-market ratio and magic formula (revised) measure
Coef
Std Err
Coef
Std Err

0.7478
(0.4901)
0.6662
(0.4813)

1.0296
(0.0964)
1.0241
(0.0898)

***
***

0.3573
(0.1509)
0.3707
(0.1591)

**
**

0.3391
(0.1543)
0.3269
(0.1501)

**
**

0.6700
0.3782
(0.1254)

***

0.6800

Table 9. Time-series Regressions of Size Portfolio Returns on the Risk Factors

The dependent variable of the regression is the value-weighted return of 5 size portfolios formed on the quantile breakpoints of the size measure. We use the natural
logarithm of the market capitalization as the weights. We report the estimated coefficients and the Newey-West standard errors in brackets. There are 156 months. Panel A
reports the estimates on the market, size, value and magic formula measures, and Panel B shows the estimates using the ROC (revised) instead of ROC when we compute the
magic formula measure. *, **, and *** are used to indicate the significance level of 10%, 5% and 1%.
Intercept
Size Portfolio 1
Size Portfolio 2
Size Portfolio 3
Size Portfolio 4
Size Portfolio 5

Size Portfolio 1
Size Portfolio 2
Size Portfolio 3
Size Portfolio 4
Size Portfolio 5

MKT
SIZE_SMB
BM_HML
MF_HML
Panel A Subsample 1 of stocks with positive size, book-to-market ratio and magic formula measure
0.9166
1.0812
***
1.2936
***
0.8325
***
0.2824
(0.6470)
(0.1120)
(0.2956)
(0.3128)
(0.1702)
-0.0053
1.0489
***
0.9489
***
0.6883
***
0.3335
(0.5899)
(0.1035)
(0.2233)
(0.2216)
(0.1374)
-0.2391
1.0790
***
0.7413
***
0.4167
**
0.4337
(0.5262)
(0.1065)
(0.1643)
(0.1727)
(0.1354)
-0.1405
1.0590
***
0.3768
**
0.3387
*
0.4422
(0.5693)
(0.1222)
(0.1695)
(0.1913)
(0.1459)
0.7897
**
1.0910
***
-0.0444
0.0207
0.2690
(0.4280)
(0.0729)
(0.1564)
(0.1428)
(0.1178)
Panel B Subsample 2 of stocks with positive size, book-to-market ratio and magic formula (revised) measure
1.3640
**
1.0743
***
1.3076
***
0.6781
**
0.1082
(0.6239)
(0.1150)
(0.2884)
(0.2699)
(0.2024)
0.2023
1.0362
***
0.9510
***
0.6308
***
0.2656
(0.5498)
(0.1041)
(0.2262)
(0.1958)
(0.1424)
-0.0112
1.0686
***
0.7548
***
0.3510
**
0.4258
(0.5025)
(0.1075)
(0.1683)
(0.1502)
(0.1426)
-0.0899
1.0497
***
0.3753
**
0.3242
*
0.4159
(0.5489)
(0.1223)
(0.1707)
(0.1782)
(0.1364)
0.6870
*
1.0791
***
-0.0777
0.0870
0.2386
(0.4046)
(0.0735)
(0.1609)
(0.1269)
(0.1179)

Adj R-Square
*

0.5758

**

0.6059

***

0.6145

***

0.5924

**

0.7324

0.5840
*

0.6141

***

0.6228

***

0.5942

**

0.7328

Table 10. Estimated Risk Premiums with Fama-MacBeth Regressions (from 07/2002-06/2014)
This table shows the risk premiums estimated from the Fama-Macbeth regressions. We first regress the excess returns of stocks against the risk factors for rolling windows of
12 months and estimate the beta for each risk factor and each stock. In the second stage, we run cross-sectional regressions of the stock excess returns on the estimated betas
of risk factors for each month. The risk premiums of factors are determined as the time-series average of the estimated coefficients of the cross-sectional regression. In the
table below, we report the time-series average of estimated coefficients and the Newey-West standard errors. There are 144 months of estimates from July 2002 to June 2014.
Panel A reports the estimates on risk factors of size, value and MF1 which is calculated from the magic formula as the sum of the rank of ROC and the rank of EY. Panel B
shows the estimates on size, value and MF2 factors where magic formula is revised using ROC (revised) instead of ROC in the calculation. *, **, and *** are used to indicate
the significance level of 10%, 5% and 1%.
MKT

SIZE_SMB

BM_HML

MF_HML

Panel AFama-MacBeth Estimates on Size, B/M Ratio and MF1

Coef
Std Err
Coef
Std Err

-0.0385
(0.1718)
-0.0798
(0.1672)

0.0752
(0.0759)
0.0509
(0.0783)

-0.0586
(0.0596)
-0.0804
(0.06)

0.1921
(0.0495)

***

0.1507
(0.0532)

***

Panel BFama-MacBeth Estimates on Size, B/M Ratio and MF2

Coef
Std Err
Coef
Std Err

-0.0191
(0.1655)
-0.0351
(0.1711)

0.0152
(0.0629)
0.0312
(0.0684)

0.0088
(0.0488)
-0.0391
(0.0472)

Table 11. Estimated Risk Premiums with Fama MacBeth Regressions (from 07/2007-06/2014)
This tables report the estimated risk premiums of the risk factors following the Fama-MacBeth regressions for a sub-period of the sample from July 2007 to June 2014. There
are 84 months included. The time-series average of estimated risk premiums and the Newey-West standard errors are reported. Panel A shows the estimates on risk factors of
size, value and MF1, and Panel B shows the estimates on size, value and MF2 factors where magic formula measure is revised using ROC (revised) instead of ROC in the
calculation. *, **, and *** are used to indicate the significance level of 10%, 5% and 1%.

MKT

SIZE_SMB

BM_HML

MF_HML

Panel AFama-MacBeth Estimates on Size, B/M Ratio and MF1

Coef
Std Err
Coef
Std Err

0.1307
(0.2529)
0.0784
(0.2425)

-0.0310
(0.0743)
-0.0344
(0.0750)

-0.0259
(0.0374)
-0.0314
(0.0361)

0.1613
(0.0534)

***

0.1130
(0.0491)

**

Panel BFama-MacBeth Estimates on Size, B/M Ratio and MF2

Coef
Std Err
Coef
Std Err

0.1170
(0.2568)
0.1594
(0.2522)

-0.0437
(0.0744)
-0.0559
(0.0732)

-0.0150
(0.0414)
-0.0229
(0.0424)

Figure 1. Equal-weighted Monthly

y Portfolio R
Returns
i
10 portfo
olios accordingg to the risk measures,
m
i.e. size, book-to--market ratio, return on
The stockks are sorted into
capital, eearnings yieldd and the ran
nkings calcullated accordin
ng to the magic formula. The return on
o capital
employedd is calculatedd in two ways, denoted as R
ROC and ROC
C (revised), an
nd MF1 and M
MF2 refer to thee rankings
computedd with ROC and
a ROC (rev
vised), respecttively. We callculate the porrtfolio returnss as the equal-weighted
means off the monthlyy returns of th
he stocks in eaach portfolio and report th
he average porrtfolio returnss over the
sample period in the fiigures below.

Sizze Portfolios

B/M Ratio
R
Portfoliios
3.00
0

3.000

Return (%)

Return (%)

4.000

2.000
1.000
0.000

2.00
0
1.00
0
0.00
0

1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decile

ROC Portfolios

ROC (reevised) Portfo

folios
3.00
0
Return (%)

Return (%)

3.000
2.000
1.000
0.000

2.00
0
1.00
0
0.00
0

1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decile

EY
Y Portfolios

MF
F1 Portfolios
3.00
0
Return (%)

Return (%)

3.000
2.000
1.000
0.000

1.00
0
0.00
0

1 2 3 4 5 6 7 8 9 10
Decile

MF
F2 Portfolios
3.000
Return (%)

2.00
0

2.000
1.000
0.000
1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decile

Figure 2. Value-weigh
hted Monthly
y Portfolio Reeturns
i
10 portfo
olios accordingg to the risk measures,
m
i.e. size, book-to--market ratio, return on
The stockks are sorted into
capital, eearnings yieldd and the ran
nkings calcullated accordin
ng to the magic formula. The return on
o capital
employedd is calculatedd in two ways, denoted as R
ROC and ROC
C (revised), an
nd MF1 and M
MF2 refer to thee rankings
computedd with ROC and ROC (revise),
(
respeectively. The portfolio returns are weeighted by th
he market
capitalizaation of the stocks
s
in each
h month. Thee figures belo
ow shows thee average porrtfolio returnss over the
sample period.

10.000
8.000
6.000
4.000
2.000
0.000

B/M Ratio
R
Portfollios
Return (%)

Return (%)

Size Portfolios
12.0
00
10.0
00
8.0
00
6.0
00
4.0
00
2.0
00
0.0
00

1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decile

ROC
C Portfolios

ROC (reevised) Portffolios

Return (%)

Return (%)

6.000
4.000
2.000
0.000

12.0
00
10.0
00
8.0
00
6.0
00
4.0
00
2.0
00
0.0
00

1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decile

MF1 Portfoolios
4.00

10.000
8.000
6.000
4.000
2.000
0.000

( )
Return (%)

Return (%)

EY
Y Portfolios

0.00
1 2 3 4 5 6 7 8 9 10
Decile

MF
F2 Portfolios
Return (%)

2.00

10.000
8.000
6.000
4.000
2.000
0.000
1 2 3 4 5 6 7 8 9 10
Decile

1 2 3 4 5 6 7 8 9 10
Decilee

F
Figure 3. Equal-w
weighted Averagee Returns on Dou
uble-sorted Portffolios
W
We construct six pportfolios with siize and one of rissk factors, and caalculated the equaal-weighted geom
metric means of th
he portfolio return
ns. The returns are
a
aannualized and repported in percenttage level. We usee the median valuue of the size meeasure to separatee the stocks into Big

and Smalll group. For oth

her
m
measures, the stoccks with the measu
ure larger than thee 70th percentile bbreakpoint are cateegorized as the H
High group. Stock
ks with the measu
ure smaller than th
he
th
330 percentile breaakpoint are catego
orized as the Low
w group. The resst are in the Midd
dle group.

20.00
S
B
Medium

20.00

Higgh

Low

20.00
S
B
Medium

L
Low

Annualized Return (%)

Annualized Return (%)

40.00

0.00

B
Medium

Low

40.00
20.00

H
High

20.00
S
Higgh

B
Medium

Low

B
Medium

Low

Size and
a MF2 (23) Po
ortfolios

40.00

0.00

0.00

Size annd MF1 (23) Po

ortfolios

Size annd EY (23) Porttfolios

Highh

0.00

Annualized Return (%)

Highh

40.00

Annualized Return (%)

40.00

0.00

Size and
a ROC (Revised
d) (23)
Portfolios

Size annd ROC (23) Portfolios

P
Annualized Return (%)

Annualized Return (%)

Size and B
B/M Ratio (23) Portfolios
P

40.00
20.00
S

0.00
Hiigh

B
Medium

Low

F
Figure 4. Value-w
weighted Averagee Returns on Dou
uble-sorted Portffolios
W
We construct six pportfolios with size and one of risk factors, and calcuulated the annualizzed portfolio returrns value-weighteed by the natural logarithm of mark
ket
ccapitalization. We use the median value of the size measure to separrate the stocks in
nto Big and Sm
mall group. For other measures, the
t stocks with th
he
m
measure larger thaan the 70th percen
ntile breakpoint aare categorized as the High group
p. Stocks with thee measure smallerr than the 30th peercentile breakpoiint
aare categorized as the Low group. The rest are in thhe Middle groupp.

40.00
20.00
S
Highh

B
Medium

L
Low

20.00

Higgh

40.00
20.00
S
Highh

B
Medium

L
Low

B
Medium

Low

Size and
a ROC (Revised
d) (23)
Portfolios
40.00
20.00

H
High

20.00
S
Higgh

B
Medium

Low

B
Medium

Low

Size an
nd MF2 (23) Po
ortfolios

40.00

0.00

0.00

Size annd MF1 (23) Portfolios

Annualized Return (%)

Annualized Return (%)

Size annd EY(23) Porttfolios

0.00

0.00

Annualized Return (%)

0.00

40.00

Annualized Return (%)

Size annd ROC (23) Po

ortfolios
Annualized Return (%)

Annualized Return (%)

Size and B
B/M Ratio (23) Portfolios
P

40.00
20.00
S

0.00
High

B
Medium

Low

Appendix. Stocks in the Top MF1 Decile Portfolio

The table below lists 36 stocks in the top decile MF1 portfolio selected from our sample based on the rankings calculated from the magic formula
in June, 2014. We reports the closing price of each stock at the end of the month, the market capitalization calculated as the closing price times the
common shares outstanding, and the monthly return in percentage.

Code

Company Name

Closing Price

Market Capitalization
(Million)

Return
(%)

HK1008

BRILLIANT CIRCLE HLDGS INTL

1.28

1905.24

-2.15

HK1023

SITOY GROUP HOLDINGS LTD

4.73

4737.25

0.43

HK113

DICKSON CONCEPTS (INTL) LTD

4.72

1800.51

2.83

HK1146

CHINA OUTFITTERS HOLDINGS

1.12

3858.90

0.90

HK1149

ANXIN-CHINA HOLDINGS LTD

1.04

3183.43

-0.97

HK1240

SUNLEY HOLDINGS LTD

2.73

819.00

8.33

HK1300

TRIGIANT GROUP LTD

2.11

2352.65

3.99

HK1335

SHEEN TAI HLDGS GROUP CO LTD

1.73

719.11

12.79

HK1388

EMBRY HOLDINGS LTD

4.49

1870.81

-0.22

HK175

GEELY AUTOMOBILE HLDGS LTD

2.73

24027.95

-4.30

HK1830

PERFECT SHAPE (PRC) HLDG LTD

2.31

2617.23

16.08

HK2010

REAL NUTRICEUTICAL GRP LTD

1.75

1965.31

4.79

HK2200

HOSA INTERNATIONAL LTD

2.45

4053.69

-5.77

HK2300

AMVIG HOLDINGS LTD

2.73

2515.82

-3.51

HK2302

CNNC INTL LTD

2.17

1061.50

3.33


HK2623

CHINA ZHONGSHENG RESOURCES

1.37

987.59

-0.73

HK282

NEXT MEDIA

0.85

2066.36

2.41

HK336

HUABAO INTL HLDGS LTD

4.59

14235.05

27.15

HK3777

CHINA FIBER OPTIC NETWORK

1.79

2604.45

-3.72

HK426

ONE MEDIA GROUP

0.52

208.00

-5.46

HK477

AUPU GROUP HOLDING CO LTD

0.90

939.15

3.45

HK483

BAUHAUS INTL (HLDGS) LTD

2.57

937.56

7.53

HK540

SPEEDY GLOBAL HOLDINGS LTD

0.36

213.00

4.41

HK550

CINDERELLA MEDIA GRP LTD

1.13

377.01

-6.61

HK566

HANERGY SOLAR GROUP LTD

1.19

34277.51

5.31

HK609

TIANDE CHEMICAL HLDGS LTD

1.64

1388.88

-7.87

HK623

SINOMEDIA HOLDING LTD

5.99

3384.62

-5.13

HK6838

WINOX HOLDINGS LTD

0.66

330.00

0.00

HK703

FUTURE BRIGHT HOLDINGS LTD

3.70

2568.92

-1.60

HK8039

PEGASUS ENTERTAINMENT HLDGS

0.82

393.60

0.00

HK8058

SHANDONG LUOXIN PHARM STK CO

11.18

1839.78

8.34

HK8146

MASTERCRAFT INTL HOLDINGS

0.47

225.60

-14.55

HK833

ALLTRONICS HOLDINGS LTD

1.92

664.06

0.50

HK837

CARPENTER TAN HLDGS LTD

4.76

1190.00

3.03

HK85

CHINA ELECTRS HLDGS CO LTD

1.55

2621.92

-3.74

HK873

CHINA TAIFENG BEDDINGS HLDGS

0.94

940.00

25.33