The Magic Formula for Investing on the NSE
I dipped my toes in the stock market between 2013 and 2016. In that time, I tripled my money in just over a year, and then promptly lost half of it the following year. As it happens, my caution quickly gave way to arrogance, fueled by my craving for more – and larger – gains, leading me to make riskier trades. My greed got the best of me, but I got out early.
I may have ended up with a net gain, but I wondered if others shared my experience: trading and investing felt so much like gambling. Market participants throw around words like technical and fundamental analysis yet seemed to make trades based on pessimism or optimism. Pure sentiment. As a normally risk-averse character, I wanted to discover a way of guaranteeing a successful investment almost all of the time. To do this, I decided to learn and copy the investment styles of prominent investors and use these methods to exploit the Nigerian stock market.
The Gotham Capital Investor
My search yielded a simple investment style by an investor called Joel Greenblatt, who runs the ominously named hedge fund, Gotham Capital. In a book titled, “The Little Book That Beats the Market” he lays out a relatively simple method of investing using the “Magic Formula”. In homage to the classic book, Greenblatt also runs a website that helps you screen the investments for US stocks. In Gotham Capital's first 20 years of existence, he generated an average annual growth rate of 40%. For the first 10 years alone, the fund returned 50% of your investment each year. For context, ₦1000 invested at the start would become ₦58000 after ten years.
The Magic Formula
The Magic Formula identifies quality companies that are trading at an attractive price. It does this by combining two elements when choosing an investment; companies with a high earnings yield (companies that are undervalued) and companies with a high return on invested capital (ROIC). These companies are ranked by their ROIC and earnings yield, and then a sum of the two ranks is used to give a combined score for each company. Companies with the lowest combined score, i.e. high-quality companies that are undervalued, are recommended as investments. For a detailed explanation on each ratio, you can read the full book by Greenblatt.
To test the formula, one of the investments I made was a stock called NVIDIA listed on the United States Nasdaq. The period runs between 2014 and early 2016.
As you can see it worked out quite well – I tripled the value of my investment during that period. Incredibly, I would have done even better if I had held on as the price skyrocketed once I exited. Go figure.
The Nigerian Market
I wanted to know if I could make even better returns by using the Magic Formula to invest in the Nigerian stock market. So I applied the formula here, using the companies with the lowest magic formula scores at the end of 2015 (remember, a lower score means higher ranks on earnings yield and ROIC).
I was wrong; you could not make better returns in Nigeria.
By the end of 2015, my combined investment had lost 38% of its value. The worst performing of the bunch was Unity Bank (UNITYBNK: NL) which lost 83% of its value that year, meaning your ₦1 million investment quickly turned into ₦170,000.
As we have already shown, the past few years have been wretched for investments in the NSE. The market has lost over 30% in the last three years, and with many investors – and investment strategies – losing out, the problem may not be with the Magic Formula. Meanwhile, the recession, devaluation of the naira, and high inflation meant that investments quoted in naira were suddenly worth less in real terms. Unsurprisingly, this caused a fire sale led by foreign investors.
The Magic Formula is calculated using past financial data of companies, so it does not account for the potential effect of current economic shocks. But this is also a flaw with any investment style that focuses only on company financials. While they may be a good indicator of how the company will perform in the coming year, it is based on the implicit assumption of “ceteris paribus”, a Latin phrase which roughly translates to “holding other things constant”. Had the state of the Nigerian economy stayed the same as when I made my investment, who knows, I may have made some money that year.
The point is, when investing, a crucial lesson you should always have at the back of your mind is that your analysis cannot be one dimensional. You have to be able to see the bigger picture – importantly in my case, the macroeconomic trends.