The limits of un-hedged, long-only investing in a secular bear market

In the comment thread of a previous post ("Welcome to another lost decade"), commenter Brad Castro wrote,

dividend growth investing (in high quality companies), I argue, is immensely superior to simple growth investing, and especially so during secular bear markets.

I offered this response in the comment thread,

I had the same thought five years ago, when I bought shares of PFE, GE, AB, etc. and set them up for dividend reinvestment in an IRA. Take a moment to pull up the five year charts on those stocks.

Any form of un-hedged, long-only investing insufficient in a secular bear market, unless you time your purchases so you make them at or near the secular market low in valuations.

But a chart is worth a thousand words:

Joel Greeblatt's New Back-Tested Results

A few days ago, I (and everyone else, I assume, whose e-mail address was on file at Greenblatt's Magic Formula website) received an e-mail announcing that Greenblatt's Formula Investing venture had released new back-tested results for the Magic Formula over the last ten years. Here are the results. The first number that jumped out at me was the positive double-digit return in 2007, which seemed surprising given the negative performance of my Magic Formula stocks that year. A glance at the first disclosure offered a partial explanation. From the Formula Investing site:

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.