The Magic Formula: Value, Profitability, and the Cross Section of Global Stock Returns

Abstract

Buying profitable, undervalued stocks and shorting unprofitable, overvalued stocks yields significant return differentials in North America, Europe, Japan, and Asia. Using data from 1991-2016, we test Greenblatt’s (2006) “Magic Formula” (MF) and find that a modified MF which uses gross profits as a measure of profitability yields significant abnormal returns for all size groups and in all regions. Results from double sorts and Fama-MacBeth regressions show that MF explains the cross-section of returns in addition to size, book-to-market and momentum.

Keywords: return predictability, profitability, value, magic formula, cross-section of returns

JEL Classification: F21, F30, G10, G11, G12, G15