Backtesting the Magic Formula in the Brazilian Stock Market

Abstract

This thesis performs a backtest of the Magic Formula for the Brazilian stock market in the period between 2006 and 2015. The Magic Formula methodology is a stock picking strategy that combines Return on Capital and Earnings Yield factors in a ranking system aiming to outperform the market average. We found that after correcting for survivorship bias and look-ahead bias, all the Magic Formula portfolios outperformed both Ibovespa and IBrX-100 benchmarks during the period analyzed. However, when using a asset price framework through the CAPM to nd positive and signi cant alpha, only the 0.98% alpha of top 5 portfolio resorted every 12 months regressed on Ibovespa could achieve a 90% level of signi cance while all other portfolios alphas were not signi cant at any meaning- ful level. Additionally, we perform the same exercise for portfolios constructed based on each isolated factor. We conclude that despite the fact that the Magic Formula portfolios outperformed the benchmarks we could not assure with a high level of certainty that the strategy is alpha generator, and that our results were not due to randomness.