In my last article [link] on Joel Greenblatt’s investment system we discussed two ideas that could improve the Magic Formula stock selection process. In this article I will pay attention to two other ideas that also may help to outperform standard Magic Formula selections.
In my last article on Joel Greenblatt’s investment system we discussed two ideas that could improve the Magic Formula stock selection process. The main idea was to do some further research on the real reasons behind high Returns on Capital and high Earning Yields. We recommended:
not to invest in companies that are wrongfully selected, and
to give special attention to companies with durable competitive advantages.
Over time, both ideas will in our opinion help outperforming randomly selected Magic Formula stock portfolios. In this article I will pay attention to two other ideas that also may help to outperform standard Magic Formula selections.
Idea 3: Three types of value
As investors we can distinguish three types of value:
book value
value of operational activities
value in profitable growth (growth supported by competitive advantage[s])
Both Benjamin Graham and Warren Buffett (in his partnership years) were able to generate enormous returns by simply buying stocks below book value. With book value we simply mean the value of all the possessions of a company (factories, machinery, money on bank accounts, etc.). As the financial industry reached maturity, companies selling below book value have almost ceased to exist. Also, companies that only have value in their book value probably have low Returns on their Capital. As a result, these companies will not show up on the Magic Formula screen.
Other companies have a lot of value in their operational activities. One can, for instance, think of some highly efficient (branded) cigarette manufacturers - these companies aren’t growing much anymore, but they are still highly profitable from an operational viewpoint. These types of companies will show up on the Magic Formula screen and some of them are really attractive stocks to invest in.
Some companies have, besides value in operational activities, also value in profitable growth opportunities (read: growth opportunities supported by one or more competitive advantages). As the Magic Formula selects on financial numbers already reported, the Formula doesn’t consider growth potential. As a consequence, no difference is made between companies with high or low expected growth rates. Ceteris paribus, we would opt for companies that not only have value in their operational activities but also have profitable growth opportunities.
Idea 4: Expected returns aren’t linear
The expected returns of undervalued stocks are better represented by a hyperbolic line instead of a linear line. Or, to say it differently, one should expect that the most undervalued stocks will - on average - rise faster than stocks which are only somewhat undervalued.
Because stocks will, on average, rise the fastest when they are the most undervalued, one could opt for one year holding periods instead of e.g. two or three year holding periods (when the slope of expected returns flattens). Or, maybe one should even opt for shorter holding periods or ‘checking’ periods. Of course, trading costs and tax considerations should also be taking into account with this somewhat adjusted strategy.
As we have shown in our two-part series on how to outperform the Magic Formula, there are quite some possibilities to adjust Joel Greenblatt’s Magic Formula strategy, which will likely lead to higher returns. What’s probably most interesting is that one doesn’t have to choose for one of the ideas: if you want, you can combine all of them!
In my last article on Joel Greenblatt’s investment system we discussed two ideas that could improve the Magic Formula stock selection process. The main idea was to do some further research on the real reasons behind high Returns on Capital and high Earning Yields. We recommended:
not to invest in companies that are wrongfully selected, and
to give special attention to companies with durable competitive advantages.
Over time, both ideas will in our opinion help outperforming randomly selected Magic Formula stock portfolios. In this article I will pay attention to two other ideas that also may help to outperform standard Magic Formula selections.
Idea 3: Three types of value
As investors we can distinguish three types of value:
book value
value of operational activities
value in profitable growth (growth supported by competitive advantage[s])
Both Benjamin Graham and Warren Buffett (in his partnership years) were able to generate enormous returns by simply buying stocks below book value. With book value we simply mean the value of all the possessions of a company (factories, machinery, money on bank accounts, etc.). As the financial industry reached maturity, companies selling below book value have almost ceased to exist. Also, companies that only have value in their book value probably have low Returns on their Capital. As a result, these companies will not show up on the Magic Formula screen.
Other companies have a lot of value in their operational activities. One can, for instance, think of some highly efficient (branded) cigarette manufacturers - these companies aren’t growing much anymore, but they are still highly profitable from an operational viewpoint. These types of companies will show up on the Magic Formula screen and some of them are really attractive stocks to invest in.
Some companies have, besides value in operational activities, also value in profitable growth opportunities (read: growth opportunities supported by one or more competitive advantages). As the Magic Formula selects on financial numbers already reported, the Formula doesn’t consider growth potential. As a consequence, no difference is made between companies with high or low expected growth rates. Ceteris paribus, we would opt for companies that not only have value in their operational activities but also have profitable growth opportunities.
Idea 4: Expected returns aren’t linear
The expected returns of undervalued stocks are better represented by a hyperbolic line instead of a linear line. Or, to say it differently, one should expect that the most undervalued stocks will - on average - rise faster than stocks which are only somewhat undervalued.
Because stocks will, on average, rise the fastest when they are the most undervalued, one could opt for one year holding periods instead of e.g. two or three year holding periods (when the slope of expected returns flattens). Or, maybe one should even opt for shorter holding periods or ‘checking’ periods. Of course, trading costs and tax considerations should also be taking into account with this somewhat adjusted strategy.
As we have shown in our two-part series on how to outperform the Magic Formula, there are quite some possibilities to adjust Joel Greenblatt’s Magic Formula strategy, which will likely lead to higher returns. What’s probably most interesting is that one doesn’t have to choose for one of the ideas: if you want, you can combine all of them!
