If you asked me what the inspiration for my investment models are, the answer would vary. Sometimes the idea evolves from an article at SSRN.com about some stock market anomaly. Other times it begins with a clear line of logic or reasoning. Other times, it just kind-of happens. This model I am about to share with you is the latter.
I think it may have started with an observation that Joel Greenblatt’s Magic Formula seemed to work well in the S&P 500. It is a 2-factor system that examines Earnings Yield and Return on Capital. That was the start and from there it turned into a recipe for soup where I improvise with everything in the kitchen from split peas and ham to turmeric, red wine and salsa. The sauce – not the music.
Anyway, I added in my own ranking system for the S&P 500 that heavily rewards stocks with lower liquidity. I mean, these are still S&P 500 giants – just not the biggest ones. After that, I wanted to lower some of the risk and volatility. So I cut out stocks with high short interest and stocks with abnormally large beta’s when compared to the industry average.
And from there developed a 10 stock system with a long-term annualized return of almost 19% annually. It also has shallower drawdowns in bear markets.
And then I did one better. I added in one optional rule, which you can turn off or on (default is off), that will require stocks to have a dividend yield of at least 2%. Doing this will push annual returns above 20% and would have cut your maximum loss in the last bear market to 36% instead of an average 57%.
I have the re-balance set for weekly but you will probably not want to trade weekly. It works well even if you examine and replace monthly. But this wasn’t made for some long-term buy and hold investor. The S&P 500 is super liquid and if you have a real cheap discount broker this should be fairly effortless and cost-efficient.