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Magic Formula’s: Do As I Say, Not As I Do?

September 30, 2007
10qk

Lonnie J Rush

2 followers

In my last articles, Warren Buffett's Magic Formula in 1965?” and Benjamin Graham’s Lost Magic Formula in 1976?”, I explored the use of and/or public endorsement of investment formulas by value investors Benjamin Graham, Warren Buffett, Joel Greenblatt, and Mohnish Pabrai. Given such credible endorsements, I wondered three things:

  • Is value investing a simple formula?
  • What makes a formula approach to investing so difficult to follow?
  • Did the greats actually follow a formula?

Is Value Investing a Simple Formula?

Without a sound investment philosophy, outperforming the markets over the long haul is virtually impossible. A formula is a tool to adhere to an investment philosophy. The philosophy Ben Graham taught his disciples was simple:

  • Owning a stock represents an ownership share of a business and all the rights associated with ownership.
  • The market is often times irrational due to fear and greed. This presents attractive buying opportunities.
  • Only buy businesses selling for less than their intrinsic value - margin of safety.

A simple formula emerged; buy pieces of businesses at less than their intrinsic value, regardless of market sentiment. While the value greats differed in their search and sale strategies, they all followed this simple formula. Each consistently bought businesses at prices well below their conservative assessment of intrinsic value. Some investments worked out well and others did not but they never deviated from this formula. They simply repeated it over and over again.

Warren Buffett made a compelling argument in his speech “The Superinvestors of Graham and Doddesville” that a small group of money managers that consistently applied the formula were not by coincidence also Graham disciples. All followed derivations of the value investing formula - buying one dollar of assets for significantly less - with virtually no overlap in holdings. All killed the market over long periods. Some elected to perform extensive research while others bought a basket of undervalued candidates following very little research. In fact, Walther Schloss held approximately 100 stocks that met “Graham like” screening tests. It’s been reported that he kidded with Buffett that in-depth research was unnecessary.

Charlie Munger, Warren Buffett’s business partner, says that “all intelligent investing is value investing. There is no such thing as a growth investment. Growth is just one factor in determining intrinsic value. Value investing means that the investment is bought at significantly less than the businesses’ underlying value. The term value investing is therefore redundant.

Joel Greenblatt’s formula couldn’t be any simpler. He says figure out what something is worth and pay significantly less. Interestingly, great value investors almost embarrassingly admit that value investing is painfully simple yet very difficult to execute. They are undoubtedly referring to the emotional struggle of consistently following a prescribed formula during good times and bad.

What Makes A Formula Approach To Investing So Difficult To Follow?

If value investing is a simple formula, then why is it so difficult to follow? My question led me to an interesting book titled “Way of the Turtle” by Curtis M. Faith. Faith was part of a trading experiment in the 1980’s. The experiment was funded by a successful trader who made a bet with a fellow trader that he could teach anyone to be a great trader. It was a “nurture versus nature” experiment. Faith was one of 20 people hired as part of the four year long trading experiment. The details of the trading system are not important. What is important, though, is that the formula was purely mechanical and it required traders to experience short term losses for the sake of long term gains. In other words, the formula didn’t produce consistent wins. Consistently followed, though, it produced long term wins. While some of the traders went on to do quite well, the most successful trader by a wide margin was Faith. He was the only trader that followed the formula as it was prescribed. The less successful traders tried to outsmart the formula or just plain did not have faith in it.

Below is my take on why 19 of 20 traders were unable to follow the formula.

Reasons For Following Formula

Difficulty In Following Formula

Emotionless.

Emotions create fear and greed decision making.

Minimal thinking or analysis.

High IQ’s can’t help but over analyze.

Required virtually no time or effort.

Unable to fill the downtime productively.

Long-term approach.

Difficult to follow during short term losing periods.

Painfully simple.

Non-believers did not have faith in its simplicity.

It’s also why very few people will follow Joel Greenblatt’s Magic Formula as prescribed!

Did The Greats Actually Follow A Formula?

Albert Einstein stated that there were five ascending levels of intellect: smart, intelligent, brilliant, genius, and SIMPLE! The philosophy Graham preached and the resulting formula, e.g. pay less than intrinsic value, is painfully simple. While search and sale strategies may be unique among investment managers, buying assets for less than their intrinsic value regardless of market sentiment is not. In fact, it is the common thread across all successful value managers.They are successful because they, like Curtis Faith, consistently applied the formula even after several years of underperformance. They didn’t second guess the formula or make it more difficult than it had to be. They achieved the highest level of intellect!

Often times, investors forget that consistently outperforming the market is an impossible task. Consistently means all the time. The great value investors don’t consistently outperform the market. Nobody does. Instead, the greats consistently follow the “pay less than intrinsic value” formula and over the long haul outperform the market.Consistently applying the formula is what makes them rare! Superior long-term results are just the by-product.

Whether investors choose to follow Greenblatt’s Magic Formula, Graham’s 1976 formula, Buffett’s relatively undervalued strategy, or Pabrai’s suggestion to adopt a slightly modified version of the Magic Formula, they’ll likely do just fine over the long term. The formulas are just a means to an end. All offer above average odds of identifying undervalued businesses for purchase. Investors should never lose sight of the fact that the magic formula is not in the search and sale strategy but in the consistent purchase of undervalued assets, regardless of market sentiment. Intelligent investors consistently apply the formula.

When the investment landscape looks confusing and it seems that everyone is pitching a magic formula, this excerpt from Benjamin Graham’s “The Intelligent Investor” helps to block out the noise.

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy…”

That’s the magic formula!

 

About the author:

Lonnie J Rush
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.0/5 (75 votes)

Comments

ivanofsf
Ivanofsf - 7 years ago
well said ! I have read many of the books mentioned in your comentary.. very true all of what you said, i too have had a hard time feeling confident following a system blindly. I have since found a value system that has done really well over the past 25 years consistently. I know i can follow it because there is a guide to help keep me on the course even when growth stocks and international fly to the top currently.
commodity
Commodity - 7 years ago
Just avoid the value traps.
commodity
Commodity - 7 years ago
It is human nature to gamble in stocks.
barrettltd
Barrettltd - 7 years ago
Superb article to go with with your earlier excellent one on Ben Graham. Thanks very much.
valuefan
Valuefan premium member - 7 years ago
Excellent article. I like the Magic Formula buy formula. Many of the stocks that hit my own

buy list turn out to be also on the Magic Formula buy list.

However, I have some doubts about its sell policy.

Does anyone have any feelings about the sell policy of the Magic Formula? It is different

than most sell policies. Most sell policies wait for a stock to become fully valued, or nearly

fully valued, to sell. This one sells in a year, if not a buy at that time.

ccyork
Ccyork - 7 years ago
most value managers will tell you that they do not know the best time to sell a stock, that knowing when to sell is much more difficult than knowing when to buy.

they all say this even when they have a defined sell strategy. i know this will upset some people but even warren buffett obviously finds this a conundrum. he has solved the problem by investing in companies that he hopefully will never have to sell

mason hawkins sells at 90% of intrinsic value. david dreman sells when a stock is valued at the market average. these strategies often miss out on large capital gains

however all of the strategies above are successful because they are disciplined. what is important is to choose a discipline and to follow it

the magic formula uses a time-based sell strategy because it is intended to be usable by people who know absolutely nothing about security analysis. and it works. why? because it is disciplined

can one use another sell strategy with the magic formula and still be successful? i'm sure they can. as long as the sell strategy is...you guessed it...disciplined

share and enjoy
billytickets
Billytickets - 7 years ago
well put cc york. the key is it is consistent. Although I did not "list it" in my book my "theory" is to sell stocks ( the ones that meet my parmeters not any and ALL companies) when the PE is 25 .

in 2001 when 8 of the top 11 ROE stocks in the Dow had a PE over 30 certainly the market was overvalued.

My"plan" is to buy lower PE strong companies like WEB does and hold them until the PE becomes 25 which should only happen during times of "severe" overvaluation.

To switch something EXCELLENT because its at 95% value pay the capital gains to sell it and buy something at 60% value sounds EASIER than it really is as ccyork and others have accurately stated
armeetofo
Armeetofo - 7 years ago
people love to believe in somthing in the first place, doubt after and abuse it eventually.

almost no one can follow it from the very beginning to the end,

i notice it

jessiema28
Jessiema28 - 7 years ago
How come it never showed up any trading activities or positions with Joel Greenblatt in gurufocus? Did I miss somthing here on the website? Appreciate any comment, I read his book and found that his analysis about spinoffs are especially useful. It would be nice to look at his recent positions.
Jehnavi
Jehnavi - 4 years ago
I’m hoping for less turbulence in the markets next year, especially as the Fed’s quantitative easing ends and market forces take over. We won’t know until 2010 comes, though… Btw, where can I subscribe to your feed.

Thanks

Knowing when sell a stock.

jharna
Jharna - 3 years ago
I’m hoping for less turbulence in the markets next year, especially as the Fed’s quantitative easing ends and market forces take over. We won’t know until 2010 comes, though… Btw, where can I subscribe to your feed.

Inside Dollars

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