The Most Magical Formula of All

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I'm embarking on a thought exercise to find the holy grail of investing. It is a formula that not only beats the market when the market is going gangbusters, but it vastly outperforms in bearish swoons -- let's call it the Most Magical Formula of All (MMFA). This is an effort to overcome the value investor's curse of doing well in times of turmoil while underperforming when the bulls stampede.

My first attempt at systematically searching for the MMFA has been greatly aided by the American Association of Individual Investor's (AAII) presentation of a wide assortment of stock screens and their annual results over the last 8 years. This information has allowed me to see which strategies have done best when the market did well as well as which strategies did best when the market dropped. A feature of AAII's screen is that they are based on famous investor's methods, so the screening techniques are widely known.

Here's how I am going to proceed:

1. Take the top ten performing strategies during both the top three up and down years of the last eight years.

2. Break the screening criteria from each strategy into their respective categories (valuation, business quality, business safety, growth, technical indicators, etc.)

3. Assess which factors in each category possess the greatest utility.

4. Synthesize the best bull factors into a practical formula -- back test for validation.

5. Synthesize the best bear factors into a practical formula -- back test for validation.

6. Effectively recombine the revised bull/bear factors into a joint screen (the MMFA); this would be accomplished by observing the most significant common variables that work in both bull and bear markets -- back test for validation

I understand that combining bull and bear strategies sounds like mixing oil and water, but you will see that there is an overlap of value and growth strategies that excel in both bulls and bears. There should be at least some complementary criteria between the two that will actually turn up companies for selection.

Here are the best bull market strategies, their style category, and their compound annual growth rate relative to the market in bull conditions:

- Estimate Revisions up 5% / Specialty / 73% versus 24%
- Foolish Small Cap 8 / Growth / 64% versus 24%
- Piotroski / Value / 56% versus 24%
- Dual Cash Flow / Specialty / 53% versus 24%
- Magic Formula / Value / 51% versus 24%
- Zweig / Value & Growth / 51% versus 24%
- O'Neil's CAN SLIM / Growth / 46% versus 24%
- O'Shaughnessy Growth / Value & Growth / 40% versus 24%
- Oberweiss Octagon / Vaue & Growth / 37% versus 24%
- Stock Market Winners / Value & Growth / 35% versus 24%

Here are the best bear market strategies, their style category, and their compound annual growth rate relative to the market in bear conditions:

- Graham Enterprising Investor / Value / 40% versus -16%
- Zweig / Value & Growth / 39% versus -16%
- Neff / Value / 38% versus -16%
- O'Neil's CAN SLIM / Growth / 37% versus -16%
- Foolish Small Cap 8 Revised / Growth / 34% versus -16%
- Stock Market Winners / Value & Growth / 34% versus -16%
- Dividend Screen Non-DRPs / Value / 32% versus -16%
- Price-to-Free Cash Flow / Value / 30% versus -16%
- Fundamental Rule of Thumb / Value / 24% versus -16%

Note that the average annual outperformance of the bull strategies comes to 27%. For the best bear strategies, the average annual outperformance is 50%. Also, I included Joel Greenblatt's Magic Formula because I am so partial to it.

My prediction is that the MMFA will end up selecting companies with good/improving economics, low debt, reasonable valuations, and recently rising share prices.

- Ian