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
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
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