42 Pages Posted: 22 Apr 2017 Last revised: 5 May 2017
Date Written: May 4, 2017
Value and profitability, both determinants of the cross section of returns, are complimentary characteristics as investors prefer to buy profitable, undervalued stocks and short unprofitable, overvalued stocks. Greenblatt (2006, 2010) proposes a methodology, referred to as the “Magic Formula”, for combining the two characteristics into a single measure. We test whether the magic formula (MF) explains the cross-section of global returns using a sample of equity returns representing twenty-three countries divided into the four regions of North America, Europe, Japan, and Asia over 1991-2016. We find that MF fails to generate significant abnormal returns; however, a slightly modified version of the magic formula that uses gross profits instead of EBIT as the measure of profitability yields economically large and statistically significant risk adjusted returns in all regions. Moreover, portfolios constructed using MF lead to significantly negative market betas. Equal-weighted portfolios comprised of the value-weighted market portfolios and the MF portfolios yield Sharpe ratios that are twice those of the each region’s market portfolio. Double sorting MF with size and with book-to-market produces return differentials that are significant for all size and most B/M groups, and Fama-MacBeth regressions reveal that MF explains the cross-section of returns in addition to size, B/M and momentum thus demonstrating that FM captures a dimension of returns not explained by the widely used characteristics.
Keywords: return predictability, profitability, value, magic formula, cross-section of returns
JEL Classification: F21, F30, G10, G11, G12, G15
Suggested Citation: Suggested Citation
Blackburn, Douglas W. and Cakici, Nusret, The Magic Formula: Value, Profitability, and the Cross Section of Global Stock Returns (May 4, 2017). Available at SSRN: https://ssrn.com/abstract=2956448