The results of the model portfolio performance:
- Reflect the strategy of buying an equity portfolio of 24 top-ranked US listed equities that are within the 20% largest companies, as measured by market capitalization. As of June 30, 2009, these companies would have market capitalizations of approximately $890 million or greater.
Well, limiting one's portfolio to names of $890 million or greater would certainly have kept you from micro cap Magic Formula stocks such as these two1:
Why, one might ask, would someone have bought micro cap Magic Formula stocks in the first place? Greenblatt's book2 suggested two reasons:
1) The back-tested results for the all-cap version of the Magic Formula, which included micro-cap stocks, were higher than those of the larger cap version: 30.8% per year, on average, versus 22.9% for the larger cap version.
2) The worst one-year return for the all-cap version was -4% (in 2002) versus -25.3% for the larger cap version (also in 2002).
Recently though, as I noted in a previous post, Greenblatt raised the minimum market cap on the screener on his Magic Formula site from $1 million to $50 million. It's too bad he refused to explain why he did this during his recent Q&A with GuruFocus readers. My guess is that Greenblatt back-tested the numbers for all-cap portfolios since his book was published and found those numbers were uglier than he expected.
1Another simple modification to the Magic Formula would also have eliminated these two names: including a requirement that each company have positive earnings in each of its previous four quarters. Neither of these companies were consistently profitable; each had one windfall quarter in the last four, and in both cases the windfall was from a one-time legal settlement. I knew this at the time, but (perhaps I over-thought this) I assumed that the inclusion of these sorts of speculative stocks was the reason for the higher back-tested returns of the all-cap portfolios. Perhaps it was.
2See pages 56 and 61, respectively, of The Little Book that Beats the Market.