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Benjamin Graham’s Lost Magic Formula in 1976?

July 09, 2007
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Lonnie J Rush

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In my recent article titled Warren Buffett’s Magic Formula in 1965?” I entertained the idea that Buffett employed a similar version of Joel Greenblatt’s Magic Formula (MF) found inThe Little Book That Beats the Market.As a follow up, I re-read many of Benjamin Graham’s writings including his best selling books Security Analysis and The Intelligent Investor. After several days of investigation, I found a nugget of wisdom related to my previous article that I hope is worth sharing. I did not find it though in one of the five editions of Security Analysis nor did I find it in one of the four editions of The Intelligent Investor. Rather, I found it in interviews Graham graciously did just before he died September 21, 1976.

Benjamin Graham started his career on Wall Street in 1914 and was a millionaire by the age of 35. He retired from professional investing in 1956 but continued to follow the market while releasing updated versions of his masterpieces. Regarded as the father of value investing, Graham spent decades analyzing thousands of companies, practically inventing the security analyst profession, and documenting the value investment framework for many to follow today.

While reading these interviews he did between age 79 and 82, I got the feeling that Graham was enthusiastic as he described a new mechanical formula he had nearly finished testing. He believed his formula was the simplest way for both seasoned analysts and layman investors to find undervalued stocks and outperform the Dow (the performance metric used during his time). After 60 years of analyzing financial statements and managements, Graham said this about projecting earnings, evaluating market share, and analyzing individual companies:

“Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. My investigations have convinced me you can predetermine these logical “buy” and “sell” levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.”

This is not what you’d expect from the author of the bible of value investing and the original advocate of the Chartered Financial Analysts organization, renowned for their high analytical standards. Human nature would be to defend his 60 years of investment contributions which preached steadfast adherence to rigorous analysis. Instead, at 82 he was still open to new ideas while in search of the simplest method of selecting bargain stocks. His formula went through two iterations. He introduced the first formula at age 79 and concluded from his results that one would have performed quite well from 1961-1976 by buying stocks with the lowest values of these three criteria:

  • A low multiple (e.g.,10) of the preceding year’s earnings;
  • A price equal to half the previous market high (“to indicate that there has been considerable shrinkage”);
  • Net Asset Value. (I presume this is the lowest price relative to book value)

In his next interview published in Medical Economics, September 20, 1976 titled “The Simplest Way to Select Bargain Stocks” Graham, then 82, proposed a simpler, more refined formula that consisted of:

  • PE Ratio of 7x-10x or less (Based on 2x current AAA bond rates)*;
  • Equity/Asset Ration of .5 or more (e.g. Debt/Equity >1).

* Calculate the maximum PE by dividing (2 x AAA bond rate) by 100. Example: 7% AAA bond would equate to PE of 7x (100/ (2x7)). If rates are below 5%, then use 10x PE max. Graham said always buy at PE 7x or less regardless of AAA rates.

Graham further recommended building a portfolio of 30 diversified stocks meeting such criteria. His study employed strict sale rules that required selling the stocks after a 50% gain or after a two year holding period, whichever came first. Graham noted that in the market downturn of 1973-1974 investors using the formula would have shown paper losses but would have been rewarded soon thereafter for sticking with the formula. Thus, to allow time for the program to work he recommended a minimum of five years. In other words, patience was a requirement for success.

Graham back tested the period from 1926-1976 with his refined formula and concluded that such a program would have earned 15% or more, not including dividends, and would have beaten the Dow by twice as much. He was so excited by the study results that he contemplated including them in the 5 th edition of Security Analysis.

In the early 1970’s Graham was working on the 5 th and final edition of Security Analysis. My evidence suggests that he was virtually complete in 1976. Interestingly enough, while scrolling through the 5 th edition searching for any mention of his formula, I realized that the 5 th edition was not released until 1988. It was published a full 12 years after his death and 26 years since the 4 th edition. His death in late1976 certainly could have delayed publishing. However, a statement in one of his final interviews suggested that publishing the 5 th edition may no longer have been a priority. When asked about Security Analysis, his response was;

“They called it the “Bible of Graham and Dodd.” Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.”

Wow! Did Graham feel so strongly about his newfound approach that he no longer had an interest in releasing the final edition? Even more disturbing, I have been unable to find evidence that he, nor any anyone else on his behalf, pursued his study any further. Not only was the book delayed by 12 years, more importantly, his study results were likely tossed aside. My guess is that had Graham lived longer it is likely he would have introduced the study in a new book dedicated solely to the formula. What a treat it would have been to see the father of value investing evolve to such simplicity. It would be nearly 30 years before a reputable investment manager introduced a similar formula.

Graham’s formula bears resemblance to Joel Greenblatt’s MF found in The Little Book That Beats the Market. While Graham used a “financial stability” metric (e.g. equity/assets) and Greenblatt used a profitability metric (e.g. Return on Invested Capital), both recommended buying the same number of cheap stocks. In addition, they recommended strict sale rules while both outperformed the market by more than 100%. Below is a comparison of Joel Greenblatt’s MF and Benjamin Graham’s prescribed formula in 1976.

 

Formula Comparison

Graham

Greenblatt’s Magic Formula

Screen Criteria

7x-10x PE or less and

equity/assets > .5

Highest Combo of EY

and ROIC

Holding period

2 years or 50% gain, whichever came first

1 year (sale losers 1 day prior and winners 1 day after)

P/E

TTM

TTM

# of stocks

30

30

Minimum Time

5 years

3-5 years

Test period

50 years

(1926-1976)

17 years

(1988-2004)

Test returns

2x Dow

2x-2.5x S&P

I found that by setting up a “Graham” screen with the above criteria (excluding financials, utilities, and ADR’s as prescribed in the MF) there is considerable overlap of potentially undervalued stocks when compared to Top 25-100 MF stocks at magicformulainvesting.com

Mohnish Pabrai, managing partner of Pabrai Investment Funds, has trounced the market since 1999. He has returned more than 28% after fees by operating a portfolio of approximately 10 stocks bought at 50% discounts to intrinsic value. Despite his enormous success, Pabrai in his best selling book The Dhandho Investor noted that investors would do quite well simply following Greenblatt’s MF. He went on to say;

“The Magic Formula is a very good place to go hunting for fifty-cent dollar bills. We could keep it very simple, only analyzing Magic Formula stocks day in and day out, and become quite wealthy over time. I strongly recommend this approach. It is simple. You’re shooting fish in a small barrel, and the results are likely to be vastly superior to the indexes.”

Benjamin Graham, Joel Greenblatt and Mohnish Pabrai combined represent more than 100 years of investment experience and annualized returns far superior to the market. And they all did it with in-depth, company-specific analysis. Yet, all three recommend a simple, mechanical approach for outperforming the market. I find it fascinating that this seemingly complex group of investors known for their stock picking abilities recommended a painfully simple approach that requires virtually no thinking or analysis.

So there you have it. Graham, the father of value investing, reduced intelligent investing to a mind-less formula a 10 year old could successfully implement. Buffett, as I suggested in my previous article, may have used a “relatively” undervalued approach in 1965 similar to Greenblatt’s Magic Formula. And lastly Pabrai, a modern day value investor that has handily outperformed the market, recommends the Magic Formula approach as a simple means to outperforming the market.

Simple and easy enough, right?

In the last of 3 articles on magic formulas titled “Magic Formula’s: Do As I Say, Not As I Do” I will argue that value investing is a mechanical formula and explore why most people are simply unable to follow a mechanical formula even after compelling evidence that such a technique outperforms the market.

 

About the author:

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

Rating: 4.3/5 (89 votes)

Comments

Valuenow
Valuenow - 7 years ago
Hi Lonnie:

There are a few academic studies on Ben Graham's various automatic selection rules. For the net current asset rule, see "An empirical analysis of Ben Graham's net current asset rule" by Joseph Vue (The Financial Review, Vol 23, May 1988).

In article published in Forbes (1977) shortly after his death he listed 10 criteria. The paper "A test of Ben Graham's stock selection criteria" by Henry Oppenheimer (Financial Analysts Journal, Sep-Oct 1984) does a backtest of these crieria.

Also there is a paper "Ben Graham's net current asset values: a performaance update" by Oppenheimer (Financial Analysts J, Nov-Dec 1986) that performs a back test.

There used to be a website called something like www.netassetvalue.com that tracked stocks in markets around the world that satisfied the net current asset criteria. As I recall, around 1998 there were only 1 or 2 stocks in the US that passed through the criteria. But lots of stocks in Japan.

I did quite well using the net current asset criteria for a few years back in 1996-98. The stocks tended to have very high inventory levels. If the company managed to keep going, the inventory could be sold at market prices. If the company collapsed, then it would be sold at cents on the dollar. This is why Buffett said that it was no fun investing in such companies and why they held 100s of stocks to offset the volatility.

Cheers,

John
yhlbb
Yhlbb - 7 years ago
One potential problem of a well publicized formula is that it may not work as effective as before. I think it still provides a good pool of stocks to investigate further. The key is a keen insight and intuition that requires years of experience and maybe a good gene to begin with.
herbertj
Herbertj - 7 years ago
This is very good stuff. I believe that when you get right down to it the crux of earnings projections is how a company is going to do relative to other companies. If that is true then it makes sense that you can do extremely well by investing in companies that have recently outperformed companies as a whole in terms of return on assets/equity and that are selling at inexpensive prices relative to recent earnings.

This is especially true since high return on assets is a pretty good proxy for both strong business models and smart and able managers.

I have always wondered why the greatest investors do so much earnings projections analysis. This makes me suspect even more that it is not necessary to make intelligent investments. But one does become much more familiar with a company by trying to predict its future earnings. I guess that is sufficient benefit to justify the effort.
harison
Harison - 7 years ago
I think what these formulas show is the power of value investing and contrarian thinking. I don't think that it is wrong to think that you can encapsulate a discipline into a simple formula as Greenblatt has done. Buffett has spoken time and again, albeit a little tounge-in-cheek, of how simple really investing is.

I think this style of strictly adhering to a criteria is an excellent way for a person who does not have 60 hours a week to listen to conference calls, read all of the financial newspapers, read analyst notes, search for new opportunities. Yet it always gets back to the most important point of investing, emotion. Stocks usually don't just get cheap, they usually do so because they are facing short-term headwinds. Does the investor have the patience to hold onto a company as he watches it decline day after day, while every market pundit calls his stock a dog, while other stocks gap up 10% seemingly every week? I don't think so. That's why Greenblatt says his formula will never truly catch on.
musto
Musto - 7 years ago
I don't know how you guys feel about black box formulas for investing, but

I personally don't feel comfortable using them.

Of all the formulas, I respect greenblatt's magic formula the most, and I try hard to

think of circumstances where his system (of buying a whole bunch of magic stocks and then selling after a year) wouldn't work. So far, I can't find anything wrong with it, but I worry that, just because I can't see any holes in it wouldn't neccessarily mean there aren't any.

I'm also quite content with my own approach that's worked fairly well for me.

By the way, Greenblatt's own portfolio is very concentrated, which would mean

he's not using the magic system. Is anyone aware of the reasons why?

herbertj
Herbertj - 7 years ago
Musto:

Greenblatt says that the formula is sufficiently accurate that an investor will beat the market over time by holding 25 to 30 stocks but that if an investor really knows what he is doing then he can beat the formula by analyzing the stocks in the screen and choosing the best few. He emphasizes that he thinks there are very few people who can analyze stocks well enough to improve on the formula. He is obviously one of the few which is why he runs a concentrated portfolio.

I have run the formula for about 18 months and my winners have outnumbered my losers by about 2 to 1. The average gains have also been larger than the average losses which make sense because a stock can only go down to zero. The diversification seems to be important for less knowledgeable investors to take advantage of the formula's favorable probabilities. Remarkably about 7 of my 40 or so formula stocks have been acquired or experienced some other large premium type event resulting in triple digit annualized returns in every case.

I really don't think there are any holes in the formula. Companies that earn high returns on assets generally have good business models and capable management. The cheap price is often the result of the price fluctuations that all stocks experience. I do superimpose two very basic screens. (1) I choose from the companies with the business models I like best. (2) I exclude companies where the earnings prospects obviously have or will shortly change drastically, for example a pending merger with a larger company. Otherwise I just follow the formula.

I have to say some of the stocks that I was least excited about but chose just to get up to the recommended number have performed the best.

jspoores
Jspoores - 7 years ago
This formula was listed in the "Rediscovered" B. Graham book. He called it his formula for doctors.
musto
Musto - 7 years ago
herbertj,

what market cap were you picking the stocks from?

herbertj
Herbertj - 7 years ago
$50,000,000. The lowest amount recommended. By the way Monish Pabrai strongly endorses the formula. You should read his latest book if you have not already done so.
klooloola
Klooloola - 7 years ago
please correct :

Equity/Asset Ration of .5 or more (e.g. Debt/Equity >1).

to

Equity/Asset Ration of .5 or more (e.g. Debt/Equity <1).

For those who follow magic formula style stocks you can read my article on Singapore and hong kong stocks at

http://longtermequity.blogspot.com/2007/07/singapore-high-roeptb-stocks-reviewed.html


DaveinHackensack
DaveinHackensack - 7 years ago
Gurufocus,

"In the last of 3 articles on magic formulas titled “Magic Formula’s: Do As I Say, Not As I Do” I will argue that value investing is a mechanical formula and explore why most people are simply unable to follow a mechanical formula even after compelling evidence that such a technique outperforms the market."

If you want ammo for this upcoming article, you need look no further than the Yahoo! Magic Formula Investing message group. Every other poster there has thought up some "improvement" to Greenblatt's Magic Formula.

yhlbb:

"One potential problem of a well publicized formula is that it may not work as effective as before."

See my point above and Harrison's point as well about why there's no danger of everyone embracing the Magic Formula. Also, bear in mind that the Earnings Yield aspect of the formula is essentially self-correcting: as investors bid up the prices of stocks, the enterprise values of these stocks go up, which reduces their earnings yield (EY = EBIT/EV). As their earnings yields drop, the stocks fall off the Magic Formula list and are replaced by more fairly-priced stocks.

Harrison,

I've also been using a little analysis when picking from the MF list, but I tend to look at balance sheet strength. I think all my stocks have more cash on hand than debt, and most have no debt at all. I figure that gives me something of a margin of safety, particularly when buying the micro-caps (I set the minimum market cap at $1 million, though I only own one stock below $50 million right now).
harison
Harison - 7 years ago
Dave,

I think that's a good method to use, because at worst the company won't go broke and at best an activist will force them to recapitalize. That's what I look for when I go to magic formula and bareequity.com. It's been a good year for those kinds of stocks; TRLG, IPSU, and WDC are some that come to mind. I've gotten lazy in recent weeks in looking for cash rich magic formula companies, I think I'll get back to work on those tonight.
Invester
Invester - 7 years ago
Herbertj, where does Geenblatt say that $50,000 is the lowest amount recommended?

Also, does anybody have any thoughts on whether small-cap stocks that fit the magic formula screen do better than large caps and whether performance among companies that fit the screen is stratified by how highly they rank within the screen? Greenblatt's Little Book leaves out a lot of the details of his backtesting and his magicformula website leaves out a lot of the details on precisely how the companies that show up on the screen are ranked. I have a feeling this is probably on purpose, to discourage potential investors from trying to fine-tune the formula and then ending up with a bad result.
Andres.Reibel
Andres.Reibel - 6 years ago
I would be interested to hear if anybody is using his/her own screen, or are you all relying on the screens generated by Greenblatt's website?

Thanks,

Andres
rob.will
Rob.will - 4 years ago
Does anyone have this article, “The Simplest Way to Select Bargain Stocks”? I'd really appreciate if someone does, if they let me know, so I could have a copy please. Thanks in advance
sdash
Sdash - 4 years ago
www.investutils.com has a good tool for buffett and Graham intrinsic value formula calculations.

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