Sector breakdown analysis of my Magic Formula Fund

About a month ago, some friends were suggesting that perhaps the reason that my Magic Formula Fund (MFF1) is outperforming the Market (S&P 500) is simply because Magic Formula explicitly avoids purchasing any Financial (Banks, Insurance Cos, Mutual Funds, etc) and Utilities stocks. (The underlying reason for this is explained in some detail in the Little Book. I will not get into it here.) I was intrigued by my friends' arguments. So I did some analysis.

I was able to find that the Finance and Utilities sectors made up about 15% and 4% of the S&P. Here is a breakdown of all sectors:

source: http://quicktake.morningstar.com/etfnet/Snapshot.aspx?Country=USA&Symbol=IVV


And, in the last 14 months, the performance for the finance and utilities sectors have been about -20% and +12% respectively.

source: http://stockcharts.com/charts/performance/SPSectors.html


So the combined effect of those 2 sectors on the S&P500 index has been about -2.52% ((0.15 x -0.20) + (0.04 x 0.12)). Still quite short of the 10%+ difference my Magic Formula Fund has achieved so far.

Going through this exercise made me to look into my own Magic Formula Fund's sector breakdown in more detail. Below is the details of my analysis (as of about 1 month ago)  which suggests that I have invested more heavily in certain sectors than a S&P500 distribution would suggest.

Yellow colors indicate the number of stocks (out of 36) that I should have allocated to each sector. The green colors display the actual positions that I took in each sector. So I am heavy on the Service Sector (especially Business Services) and light on Manufacturing and Information sectors.

I have taken these facts into account in my last month's picks, and I plan to follow similar thinking during the upcoming months. I will try to balance out my portfolio's sector distribution similar to the S&P500's. After all, I would like to beat the S&P500 index with as close a sector distribution as possible.

Having said that, I am fully aware that sometimes the nature of the Magic Formula approach will favor certain sectors over others simply because a sector is beaten down and it just offers many good opportunities to buy good companies at cheap prices. And I might just take advantage of those opportunities.

I just upped the ante!

Since my initial Magic Formula Fund is doing so well, I decided to start a second MF fund.  So on last Friday, I sold all assets in my current retirement account (~$142k) and invested them in 36 hand picked MF stocks. I will call this new group of stocks my second Magic Formula Fund - MFF2. There is about a 80% overlap with my initial Magic Formula Fund (MFF1) stocks. 

After 4 days, my MFF2 is lagging the market by about -0.13%.  Here are the details on my second fund's (MFF2) positions:

My approach in my second fund is a little different than the one I followed in my first fund (and the one mentioned in the Little book). The book suggests to invest equal amounts each month (or quarter) for a full year and then to cycle out and in each period going forward.

I had followed this approach in my first fund (MFF1) as it took me a full year to reach approximately 36k of invested capital  in 12 months. ~36 positions of ~1k each, about 3 positions per month. And after the 12th month, I have been cycling out 3 stocks ea month and investing in 3 new ones. 

In this 2nd fund (MFF2) I committed all 36 positions at once (each position is about $2750). The question is how should I cycle them out? 3 each month starting at month 1 or month 13 or month 7? And which ones should I cycle out first? Worst performers? Or randomly?

I think I will start cycling out 3 stocks starting at month 1. I am thinking of cycling out the worst performers first.  But before deciding on this 100%, I will do a little bit more analysis on how the bad performers of month1 of MFF1 did during the rest of the year. 

Sep 2008 Picks: VSNT, ROK, VLCM

ROK - First identified last month. Looks like a strong company with solid fundamentals.
VSNT - Looks like a decent software company. Probably should have asked my friends Andy and Matt what they think of this company before buying it...
VLCM - cool products. Plus, I wanted to increase my exposure in consumer goods sector.


Also considered but passed:
BR - currently affected from the downturn in finance sector, otherwise good company.
PRXI - too small, not great track record for the time they have been public.
VCLK - not growing in a growing market. Somethings must be fundamentally wrong. Not sure if the next big Internet company will be a potential acquirer for this ad network.
MDP - Looks like a decent Media company. Maybe next month.
CF - Looks like a solid company. Maybe next month.
MSFT - Very interesting fact I noticed while I was looking more deeply in Microsoft. Their stock has pretty much been flat for the last 10 years, despite decent profit growth. Having said that, I am not sure if the future looks bright for MSFT. So I will pass for now.

Which index to benchmark against?

Some people suggested that I should not compare my results only against the S&P500 index, but I should compare them against a number of indexes, especially the Small and Mid Cap indexes as most of my stocks fall under those categories. I just did that analysis.

As you can see in the below graph, the leading indexes were all down anywhere from -9% to -15% in the last 14 months. During the same period, my Magic Formula Fund has returned 0.45%. So far my Magic Formula Fund is beating all major indexes by at least 10%. Not bad.

Indexes:
S&P500 index (S&P500)
S&P 600 Small Cap index (.SPCY)
S&P 400 Mid Cap index (.IDX)
Russell 2000 index (IWM)