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Some Thoughts on Joel Greenblatt's Magic Formula and Its YTD Results

September 03, 2013 | About:
"Value investing is simply figuring out what something is worth and paying a lot less for it" - Joel Greenblatt

I often describe my investment philosophy as a synthesis of ideas from Ben Graham, Walter Schloss, Warren Buffett and Joel Greenblatt. At the core of my strategy is Graham and Schloss' quantitative methods for valuing stocks. It's far more difficult to make mistakes when you simply make obvious, simple decisions based on valuation. In each investment, I want to ensure I'm not taking on valuation risk. Many investors (including most value investors) overly complicate things and this can often lead to counterproductive results. That's why many smart guys get mediocre results. They try too hard.

One of the things I occasionally like to do is look at simple, diversified value portfolios I track to see how they are performing. I think of these like "value indices." Rather than track the S&P, which I hope to surpass by large margins over time, I also want to track the results of simple value indices which are very easy to replicate in practice if one wanted a passive approach that would likely beat the S&P over time. I'm talking about tracking things like the 50 S&P stocks with the lowest P/B or P/E ratios, and other simple value portfolios.

Please remember that these are hypothetical portfolios and past performance doesn't guarantee future results.

Understand Quant, But Don't Let the Computer Do 100% of the Thinking [/size]

Again, just to be clear: I don't invest in these quant strategies, I simply track a group of 8 or 10 of these portfolios, more just for fun than anything else. Most of these hypothetical portfolios are up a 20% to 35% this year, which is remarkable, but not surprising given that the market has performed very well year to date.

I don't invest using these strategies for two reasons:

  • One, I hope to do significantly better over time (three to five-year periods, any one-year period could go either way).

  • Two, although I admire a few investors who follow value quant strategies, I have never been a fan of completely systematic strategies with my own capital.
Some quants have very convincingly shown that quant strategies outperform even the smartest discretionary value investors. Their argument against making discretionary decisions is that it's too easy to have lapses in judgement and make poor decisions. This is likely true, but it's the reason value investing works. Discipline and common sense are required to have a sustained career as a value investor. And it's those traits that many lack. For those who are not disciplined, it's likely better to use a computer to tell them what stocks to choose. For these folks, I truly believe that value quant strategies will likely work very well over time relative to their own results.

But the one thing that isn't covered as much in a general sense is risk management, i.e. protecting the downside.

The Best Risk Managers Are Human

The above subtitle might be the exception rather than the norm. For many investors, a quant value strategy (or an index fund) might be less risky than managing your own portfolio. But the best investors in history have generated far better results with far less risk of permanent loss (not volatility) than the best computer systems.

My first priority in investing is protecting capital from permanent loss. In order to properly do that (in my opinion), I need to be able to know something about what I own. I don't want to invest my hard-earned capital (nor my clients' hard-earned capital) into stocks that I'm not familiar with simply because they show up on some valuation screen that has historically said that these stocks do well.

I'm not suggesting quant strategies don't work. It's clear that a variety of quantitative value strategies have done well over time (Graham's quant ideas, Greenblatt's ideas, net-nets, etc.), and will probably continue to do well in the future, but I'm just more comfortable understanding something about the investments I make. This is not to say that I understand everything about each business, but I want to be able to understand why the investment makes sense. Simply allocating across 30 to 50 value stocks without any reason (other than the computer said to) is a difficult thing to do, and even more difficult once the strategy begins to underperform for a period of time — [size=13px; ]an inevitable occurrence in just about all value strategies — they almost always work over time, but not always each month, quarter, year, etc.

Magic Formula Is My Favorite "Quant" Strategy

I've talked about Joel Greenblatt's Magic Formula before. It's a value investing strategy that uses two simple inputs (return on capital and earnings yield) to pick a group of "cheap and good" stocks. Basically, Greenblatt wanted to test the ideas he used at Gotham Capital, where he was able to make 40% annual returns for 20 years using a combination of simple value investing ideas and special situation techniques.

I believe that Greenblatt, like Ben Graham, started the project as a way to teach individual investors more than as a way to use for his proprietary funds (although he does use those ideas). He wanted to provide a simple-to-follow strategy for everyday investors to use that would be superior to an index approach.

The results of this test were published in his book, "The Little Book That Beats the Market." These results, needless to say, were astounding and surprising, even to Greenblatt himself:

1082234230.jpg

Please remember that these are back-tested results, and not guaranteed to continue.

The above is a chart I found on Jae Jun's excellent site, which was reproduced from Greenblatt's second edition of his book. The Magic Formula method of picking stocks averaged 23.8% per year versus a market average of 9.6% during the period from 1988 to 2009.



Magic Formula YTD Hypothetical Results
[/b]

So far in 2013, the Magic Formula is the best performing strategy of all the hypothetical value strategies I track. I track a list of 30 "Magic Formula" stocks with market caps over $250 million, and also a list of the top 30 over $2 billion. These lists can easily be generated at Greenblatt's Magic Formula Investing site. The smaller cap group is up about 42% year to date, and the larger group is up just under 40%. Here is a list of the top 30 Magic Formula stocks that were in the group at the beginning of the year (this is not a real money portfolio, just a hypothetical portfolio I track for fun each year):

643501510.jpg

Please remember that these are hypothetical results, without consideration for commissions, taxes, slippage, etc., and not guaranteed to continue.

Both hypothetical Magic Formula portfolios are trouncing the S&P so far in 2013. Of course, they are just as likely to trail the market average by a similar amount over such a short time frame. I just found it interesting to note the fantastic results so far year to date.

But short-term results are trivial. [b]The real takeaway is in the principles behind the strategy
. These are simple and logical.

Magic Formula's Secret Is in Its Logic and Simplicity

Greenblatt's name for his strategy is tongue in cheek. There is nothing magic about it. It simply systematizes the principles that Greenblatt used to invest for 20 years. It uses one simple metric to determine valuation and one simple metric to determine quality.

At the core, this is all I do when I invest. I try to find good companies selling at cheap prices. Valuation is the most important. As Buffett said in his 1965 letter to partners when he described what he looks for in general investments:

"Their main qualification is a bargain price; that is, an overall valuation of the enterprise substantially below what careful analysis indicates its value to a private owner to be. Again, let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management, we like a decent industry, we like a certain amount of "ferment" in a previously dormant management or stockholder group. But we demand value."

In his early days, Buffett was looking for cheap and good stocks. Just like Greenblatt. I agree with Buffett that value takes precedence over quality. The magic formula weights both of them equally, which is one reason why I choose to make my own investment decisions.

I want to ensure that what I'm buying is undervalued. I want a margin of safety in each investment. The result is a huge margin of safety at the portfolio level which contains a nice group of individual low risk undervalued securities. Insisting on a margin of safety in each individual position and also diversifying adequately also allows the portfolio to easily weather the inevitable errors that one will make. On balance, over time, this strategy works very well.

Greenblatt-an Evolution of Strategy?

I find it very interesting to study Greenblatt's career. He made 40% annual returns for 20 years using his own value investing strategy of buying cheap and good stocks along with numerous special situations. Then he came up with the systematic strategy he called the Magic Formula. But even after writing that book, he still invested using his old techniques of concentrated, disciplined value investing.

As of late, he seems to have changed his ideas on this. In his Market Wizard interview he mentioned he is now managing money using automatic quantitative strategies. However, he did say if he was starting out, he'd do the same thing he did when he started Gotham.

One of the interesting things I heard Greenblatt say at a class in Columbia I happened to watch was that he liked the Magic Formula, but preferred to invest his capital using his own decisions and common sense. I think his thinking may have evolved on this, but I agree with his original idea that the Magic Formula proves that these principles work (buying cheap and good stocks works well over time). It's just that I want to decide for myself what stocks are cheap and good.

It's more a matter of risk management than absolute performance. I may only keep up with the Magic Formula over time, and one might argue, "Why not use it in that case?" The answer for me would be risk. I want to understand what I own, so that I'm comfortable owning the shares of those businesses when the market takes a big drop. I want to know the values of my businesses, so I know how to respond to various market conditions.

After all, we own pieces of businesses, not pieces of paper.

It's just a matter of preference. I'm a numbers guy, so I love reading about quant strategies and noticing their results. But I will never forget the first two rules of investing:

  • Rule No. 1: Don't Lose Money.
  • Rule No. 2: Don't Forget Rule No. 1.
The best way I know how to manage risk is to understand something about why I own the businesses I do. I want them to be good businesses, but even more important than that, I want them to be undervalued. To sum it up, I want to ensure that I understand why I own the stock and what my general estimate of the value is.

As usual, my post got somewhat longer than I expected (but this is an interesting topic to me, so it was bound to happen!). But the easiest way to sum it up is the way I started the post, with one of my favorite quotes from Greenblatt:

"Value investing is simply figuring out what something is worth and paying a lot less for it."

That's the crux of what we're trying to do. And at its foundation, it's really just that simple.

About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


Rating: 4.0/5 (11 votes)

Comments

sapporosteve
Sapporosteve premium member - 11 months ago
Hi John,

Thanks for your articles. I find them very helpful and insightful.

One question if I may - With the MF, you can choose different factors such as market cap of $50M, $500M and similarly choose 30 stocks or 50 stock portfolios.

Is there any one selection that outperforms the others? So is 30 stocks better than 50? Does including small caps outperform large caps?

regards

Steve
varunfriend
Varunfriend premium member - 11 months ago
Great article ... just want to point out that Lorillard split at the begining of January which is why its showing as losing money. Its up over 9% without dividends YTD.

John Huber
John Huber premium member - 11 months ago
Varunfriend, yes I noticed that actually after I posted it. It actually adds a couple points to overall return.

Steve, Yeah you can choose any market cap you like above $50 million. I think the smaller caps have traditionally outperformed the larger caps, but I don't know specific numbers. I think the original results in the table are simply the top 30 Magic Formula stocks above $50 million. They aren't all necessarily small caps (some are large like AAPL, some are very small). But I think opening up your choices to everything has traditionally done better. I imagine the more concentrated portfolio does better than the diversified, but not sure.

I know Greenblatt did a decile test on the largest 2500 stocks. The top decile (about 250 stocks... these are the top 10% of the Magic Formula stocks) performed very well-around 15% per year and much better than the S&P. These results are in backtest remember, and likely don't account for commissions that you'd incur by trying to build a portfolio this large, but the point is that the system is powerful. The worst decile was down about 0.2% per year. These results are in his book.

So the diversified basket of deciles didn't perform as well as the smaller group of the top 30 magic formula stocks.
roark1
Roark1 - 11 months ago
What are your thoughts on Greenblatt's mutual funds? I established small positions in two of the funds. I like Greenblatt and his approach, but I wish the expense ratios were lower. How much of the expected outperformance will I be giving back in fees?

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