Why Magic Formula Research Excludes Utilities and Financials

Summary

The document explains why empirical studies and Magic Formula screens often exclude financial companies and utilities. Financial firms have business models and balance sheets that make leverage difficult to interpret alongside leverage at nonfinancial companies. A high debt level may be normal for a bank or insurer, while it can signal financial distress in other sectors, weakening comparisons that rely on accounting ratios.

Utilities are also structurally different: public providers may be shaped by government mandates, and utilities overall tend to have high leverage and book-to-market ratios. Their valuations can therefore be especially sensitive to interest rates. The discussion cites Fama and French’s 1992 research as support for excluding financials, while its explanation for utilities is presented as a likely rationale rather than a demonstrated universal rule. These exclusions can improve comparability in cross-sectional analysis, though they also narrow the strategy’s coverage.

Key ideas

• Financial firms’ leverage often has a different economic meaning from leverage at nonfinancial firms.
• Utility business models may be shaped by public-service roles and government decisions.
• Utilities’ high leverage and book-to-market ratios can make them sensitive to interest-rate changes.
• Sector exclusions support more comparable empirical analysis but reduce the universe being studied.

Tags

# Exclusion of Utilites and Financials in Magic Formula


# Exclusion of Utilites and Financials in Magic Formula












In Joel Greenblatt's magic formula, see https://en.wikipedia.org/wiki/Magic_formula_investing, why are utilities and financials excluded? What is the reasoning behind this?

## Answer by skoestlmeier (score 4, accepted)

https://quant.stackexchange.com/a/41196

Short answer: That is a common approach in empirical finance.

The exclusion of financial firms is due to their business model, which is highly different from other companies. Fama/French (1992), p. 429 state:

> We exclude financial firms because the high leverage that is normal for these firms probably does not have the same meaning as for non-financial firms, where high leverage more likely indicates distress.

The reason for excluding public utility firms may be due to their linkage to the state. Public firms often are not profit-orientated and are highly affected by governmental decisions. Their economic role is to serve public tasks, so their business model also differs from other private companies.

Non-public utility firms empirically also have a very high leverage and therefore untypical high book-to-market ratio, which results in a high sensitivity to interest rate changes. Given the quote above (and the fact that most utility firms are public than private), they are commonly excluded in a whole from empirical analysis.

Reference:

- Fama/French, The Cross-Section of Stock Returns, The Journal of Finance, 1992

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.