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Jonathan D. Poland
Jonathan D. Poland
Articles 

The Magic Flawmula – Did Joel Greenblatt Miss Something?

January 18, 2007

Excuse the blatant typo, Mr. Greenblatt is ultra successful! Yet as I read through his book, you know the one; I couldn’t help think he was doing the "Jim Cramer!" You know... the part where he tries to appeal to everyone all at once.

The book is a great read and very easily done within an hour or two. Again, the problem with the "magic formula" is supposed to be a long term investment strategy and it doesn't take into account consistency of the business, which is the MOST IMPORTANT factor in determining future cash flows or earnings... a la intrinsic value. All are the foundation of a long term investment strategy. Otherwise you a speculating!

Most of us never change once we're on a certain path because of our beliefs. The same holds true for corporations.

Take for instance, Freight Car America ( RAIL), which is mentioned by Joe Citarrella on the 17th of January and can be found in the top 30 on Joel Greenblatt's site www.magicformulainvesting.com. I really like Citarrella's approach and obviously you cannot argue with the success of Greenblatt's Gotham Capital, but wait just a second...

Freight Car America ( RAIL) has earned a total of $38 Million since 1999 on $3.17 Billion in sales. If the goal of an investment portfolio is to collect companies that will produce the highest amount of future earnings this company has not had their "run" because of sound investing. Now again, if history held the secret to wealth, librarians would all be super wealthy and obviously that's not the case.

This is just one example, but besides never speaking of consistency, the magic formula calls for 20 - 30 purchases each year and to rebalance them at the end of the year. (i.e. Selling the losses before the turn of the year and selling the winners after the new year for tax purposes.)

This does not seem like a great long term investment approach. Then again, Joel has written a book for the masses. And, there are approximately 100 million Americans that own mutual funds, which typically hold 30 - 300 stocks at any given time. Further investigation shows that not one of his holdings is on his own "magic formula investing" worksheet! And the companies he's invested in have the consistency other guru’s look for. Maybe he didn’t miss. Maybe he just has a different magic formula!

Then again, knowledge and education should be used for action. Take what you can use and leave the rest. I would recommend reading the book as it is very useful in narrowing down investment selections. Just my two words of investment advice: Consistency Matters!

___________________________________________

Jonathan D. Poland is the Founder, Editor and Chief of the PigsGetRich Investment Network. www.pigsgetrich.com

About the author:

Jonathan D. Poland
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 2.3/5 (30 votes)

Comments

budskaloha
Budskaloha - 10 years ago    Report SPAM
I had a hard time with the fact that Greeblatt himself did not invest his own money based on his Magic Formula. However, I did realize that he wrote the book to help the masses. This book is written for the individual who is not very educated about finance and investments. Also for the person who is not going to put the time to research and do due dilligence. However, if 75% of professional money managers cannot beat the S&P 500 index, an index based on Market Cap., than it's not too crazy to see how Greenblatt's approach could beat the S&P 500 by buying the stocks that appear on his screen at www.magicformulainvesting.com. However, it seems he only back tested this idea and it worked. Bottom line, for the average investor, he should follow Greenblatt's approach and save the on the managment fees, newsletter subscriptions, and time picking stocks. Not unless you got the skills to know a hand few of stocks so well and have the conviction to buy and hold when the market will not, and take concentrated position, only this type of investment style truly beats the market.
brianrezny
Brianrezny - 10 years ago    Report SPAM
I read the book and Joel is a real genius investor. But as Joel states, you must take a long term approach. Many investors will never do that. Following an investment plan like clock work is hard to do for the averages let alone professionals. I find the Magic Formula is a great way to help pick promising opportunities for further research. After using the Magic Formula all last year as a screening tool I did pick up some great stocks one being America Eagle Outfitters last December in the low 20’s. Maybe not a perfect system for everyone but maybe a second look would be helpful for many. John you also have a great newsletter and your last pick also shows up on the list of top 25. Just my two cents, hope it helps.
pigsgetrich
Pigsgetrich - 10 years ago    Report SPAM
You're right, I think he addresses the fundamental approach to long term investing that is to evaluate earnings and returns on capital/equity. However, I still have a hard time promoting a rebalancing of your portfolio year after year. I mean, just because a stock has or hasn't performed does not mean it should be sold. Plus, if you sell each year and incur a 15% tax penalty it takes away from your long term performance.

Think of $1 doubled each year with (a) taking taxes each year and (b) taking them at the end, even if they show as income and not capital gains the end number will always be higher! Thank you for your compliments Brian, and its obvious Joel is a very smart person. I just think he was taking the easy way out. Maybe that was the point.. haha!
Bogumil
Bogumil - 10 years ago    Report SPAM
I have to strongly disagree here. It's fairly obvious that the formula as any formula has two objectives 1/ to be simple 2/ to prove a point. Point was proven, good companies, bought at a discount perform better than the market, and indeed the formula is simple, and can be easily used by less sophisticated investors. BUT the formula is just the beginning, I do recall Greenblatt mentioning that in the book, he clearly says that if you have any additional knowledge & skills, you may apply it to further enhance your stock picking results... and the point made in the article above perfectly decribes one of the potential "enhancements" of the formula.
budskaloha
Budskaloha - 10 years ago    Report SPAM
Bogumil is right. Greenblatt's formula/book was to be simple for the average reader to implement and to prove a point against Vanguard's John Bogle and everyone else on the indexing bandwagon. Greenblatt's case is if you are already in the index camp and have most of your assets in index funds you would be better served to covert those assets into the magic formula. As for rebalancing your portfolio year after year, as long as the stocks you selected from the screen remain on the screen you can choose to continue to hold it even if it's past one year. This is clarified in the FAQ on the www.magicformulainvesting.com website. With the magic formula your sort of creating your own mutual fund based on the screen instead of an index. The screen is suppose to identify undervalued stocks. Stocks could get knocked off the screen based on two factors, 1. earnings go lower, lowering ROC and earnings yield, 2. Stock price increases lowering earnings yield. So one would only want to own stocks that appear on the screen. However, to make it simple and minimize excessive trading, if you bought a stock on the screen and it gets dropped three months later due to raising stock price or lowered earnings, Greenblatt says to hold for at least a year. And yes, because of the tax consequence it makes more sense to hold it for at least a year. What really matters is an investors net return after taxes and a buy and hold for years strategy might be better but not the scope of his book. Also, I can't think of a more simple way for the ordinary investor to improve their net returns than the magic formula. If one has an easier way, let's hear it?
visible
Visible - 10 years ago    Report SPAM
Formulas are only a small part of value investing - it's only a place to start.

You want easy... easy is waiting for the one stock you know is selling at a ridiculously low price and then buying it. Most gurus have differentiated themselves with a very few investments (Munger says if you took Warren's 10 best ideas away, he would be a very ordinary investor).

easier said than done:

It means you may have to wait a long time (people - especially money managers - with money to invest don't like to wait) and

When the price finally gets to the price you've been waiting for, there will be so many people telling you not to act, you may not be able to pull the trigger.

it's not rules, formulas, or even IQ that makes a guru, it's emotional fortitude.
pigsgetrich
Pigsgetrich - 10 years ago    Report SPAM
I understand what you guys are saying and I just like to think that investing is done for the long term. If you own a great company why sell it at the end of one year? Otherwise, I'd be a trader/speculator. I also find it interesting that someone would write a book about his formula, but not follow it. Just a thought.
bmeister
Bmeister - 10 years ago    Report SPAM
Contrary to what was stated in the article prompting the ensuing posts, it's important to point out the following >>

- JG DOES buy some of the stocks on the MFI site >> AZO, ARO just to name a couple, and keep in mind that his entire portfolio is made up of not many more than a couple

- consistency of business is reflected in historic ROIC, which ON AVERAGE, is indeed indicative of future earnings by virtue of the likelihood of continuation through time of a consistenly solid business model

- backtested results of 22-30+% annual returns cover a span of 17 years - there's nothing short-term trade-oriented about that

- JG and Cramer are quite different, especially in terms of the MFI site --- MFI mechanical strategy removes emotion while Cramer goes hog wild every hour of every day inspired by short-term results and gobs of emotion


Evan
Evan - 10 years ago    Report SPAM
Bmeister,

17yrs is not a long enough period of time to judge an investment method or trend; Benjamin Graham had a tough time taking a span of 50 years seriously.

Evan.
budskaloha
Budskaloha - 10 years ago    Report SPAM
I agree, 17 years is not that long. Don't have the book, I borrowed it from the library but I think that's as far back that they could back test with the data. I'd be satisfied if this formula can just outperform the S&P 500 long term and I have 3% of my portfolio trying to confirm if it does.

I am banking that JG is honest and would not jepordize his professional reputation if the people who followed it underperformed the S&P 500. If it did, that would be very irresponsible on his part to publish a book like that. So far I did not hear other gurus criticize his book. Only comments I heard is that this particular screen excludes stocks that are attractive to them.

If it does work long term, I would like to compare the performance against certain gurus to see how they fair against it. I view the magic formula as a the new standard to beat.
visible
Visible - 10 years ago    Report SPAM
There is NO formula that works, sorry to burst your bubble.... everyone with an opionion (or who writes a book) thinks they are right - so you can't be too mad at them if their system doesn't work. Buffett uses the analogy of a coin flipping contest, where the winner writes a book about their coin flipping "formula."

If you would be satisfied with the S&P500, by the index and eliiminate the possiblity of under-performing it.

budskaloha
Budskaloha - 10 years ago    Report SPAM
I won't really be upset if the formula does not work, it would be my fault to have lost my money by following it. I do think that JG looked at all the angles and must have a high degree of conviction behind it to publish it, if he is a person of integrity. It's not like it was a theory that was leaked out of his value investors club, but maybe if it was it would appear to be more credible.

There's no free lunch. In order to beat the S&P 500 I have to be willing to accept the possibility of under performance. And I said I would be satisfied with outperforming the index. Also, I think JG believes that Gotham Captial can outperform his Magic Formula, or why would you bother to pay him management fees for something you could do yourself?

So yes, I'm admitting that with my skills as a stock picker, maybe I should follow the magic formula instead!
sabonis
Sabonis premium member - 10 years ago
Why not just piggy back on Greenblatt's own picks and forget about the formula?
budskaloha
Budskaloha - 10 years ago    Report SPAM
Yeah, I already piggy back some of picks of the gurus here. But part of piggy backing is doing a lot of reading. You still need to have conviction in a stock, at least its story of why its cheap to pull the trigger. I've piggy backed on few picks that went to zero and they were top 10 holdings too. Take (NEW) for example. The price went down, you might think you could buy it cheaper than David Einhorn did, but I don't really know if its cheap or a mistake.

I manage the investments for my family. If I were to die no one would have a clue in how to invest. I saw the magic formula as something they could do on their own. A way to be in charge of their own investments and not be dependent on a manager. Not everyone has the time to make investments their world.
buffetteer17
Buffetteer17 premium member - 10 years ago
I'm not quite ready to put real money into a magic formula portfolio, but I've started two fantasy magic formula portfolios. In my real money portfolio, I have about 8-10 selections, based on deep and extensive research. I look for pretty much the same things as Greenblatt: low price and good return on invested capital. I don't worry much if the company is growing fast or slow.

1. Use the formula, but throw out selections that aren't rated by Morningstar or have less than a 3 star rating.

2. Same as above, but buy in-the-money LEAPs instead of the stock.

This experiment hasn't been running long, just 6 months. It'll be interesting to see how well it works after 3-5 years. I might even put a small amount of real cash into it someday. Starting cash $50,000, target number of selections 24. Adding two a month until 24 selected.

results to date (6 months):

LEAP portfolio - 38%

stock portfolio - 27%

S&P 500 - 23%

budskaloha
Budskaloha - 10 years ago    Report SPAM
buffetteer17,

I needed to put up some money in the magic formula to keep me interested but its a great idea for you to do a fantasy version until you have more confidence in it. I'm trying to make my selections very systematic. No in depth research for me. I don't have access to Morningstars ratings but I use a similar process with the Schwab Equity Ratings, ranked A to F. I run my screen of the top 100 stocks with at least a minimum market cap of 100 million. From this screen, I only pick stocks with a Schwab Equity Rating of B or higher.

I did not have the patience to wait a whole year to accumulate 28 stocks so I just bought all of them in the same month. Also, since I have them in a tax deferred account, I don't hold them for the one year period like JG explained in his book. If the stock drops off the screen I'm looking for a reason to sell it, even if I only held it for a month. My justifications vary. A good run up or rating of C or below are a good reason for a sale.

From mid december '06 til current I have purchased a total of 39 stocks, sold 11, hold 28, and up 5%

pigsgetrich
Pigsgetrich - 10 years ago    Report SPAM
I have a couple of things to say in regards to recent posts. Evan... you may be right about trends and so forth, but when your investing it's all about the now! If it's not working NOW (this year, next year...) Then you have to change your approach... Investing comes down to understanding businesses... not trends or stock prices for that matter. As Joel says himself, there are wide flucuations between high and low prices each year... and so what!

budskaloha.... if you are buying 39 stocks a year... you're not investing... you're speculating! You may as well swing trade, b/c wide diversification like that will never produce above average long term results... Look at how many mutual funds do just that and yet only 1% of all investors make over 20% a year... Take the 39 stocks and look for the ones that offer the highest Initial Rate of Return... buy 5 - 10... if that..
budskaloha
Budskaloha - 10 years ago    Report SPAM
Pigsgetrich,

You could be right. I'm not even following the magic formula the way JG has explained. However, I think the magic formula is only a tool to help identify the supposed "undervalued" group of stocks, sort of doing value profiling. We don't know which ones will actually be a big winner and honestly don't want to do the analysis to find out. This strategy would only represent a portion of my total portfolio.

I see a stock on the screen as a buy indicator and when its off the screen as a sell indicator, at least in part because there is supposedly something more undervalued to buy. I'm also thinking that a higher turnover might be benefical to this formula.
buffetteer17
Buffetteer17 premium member - 10 years ago
It takes me around 45 minutes a month to update the two fantasy magic formula portfolios. I spend about 20 hours a month on my real money portfolio (darn that day job, doesn't leave enough time). So far the stock fantasy portfolio is at a 27%/year yield (6 months), and my real money portfolio is at 26%/year yield (30 months).

I'll never put most of my money into a magic formula portfolio, because I actually enjoy the time spent investigating companies. But occasionally my stock-unsophisticated friends ask me for investment advice. I can't in good faith tell them to buy what I own. (1) I might not be available to tell them when to sell. (2) Some of my holdings have already run up past what I consider fair value. I'm slow to sell a winner, but wouldn't buy at current prices. I usually tell them to put 2/3 of their money into a total market index fund, and the other 1/3 into something besides stocks. That's okay, but it would be nice to offer them a strategy that gives a much better yield and that I really believe in.
buffetteer17
Buffetteer17 premium member - 10 years ago
The experiment after 7 months

stocks 15.4%/year

options 37.0%/year

S&P 500 16.1%/year


buffetteer17
Buffetteer17 premium member - 10 years ago
The experiment after 8 months (as of 5/18/07)

stocks 23.3%/year

options 79.3%/year!!!

S&P 500 24.1%/year

The magic formula with options is very interesting, with a yield of 79.3%/year after 8 months. Is this real? Well, this result comes from 3 huge winners out of 14 selections that gained around 200%/year. There were also 2 big losers. The thing about options is, your downside is protected...you can only lose all you bet, but your upside is unlimited. This experiment was done over a period of generally rising prices. Had there been 2 winners and 4 losers, which you might expect in a down market, the results would have been mediocre.

Still, 79%/year gains! I'm tempted to put some real money---not more than I can afford to lose without much pain---into this experiment. Clearly you don't want to finance such an experiment out of your home mortgage line of credit, but what the heck, let's gamble a little. The house odds are on your side, since generally rising markets are more common than generally falling markets.
recortes
Recortes - 10 years ago    Report SPAM
buffetteer17,

one question. The same money put in options of a S&P500 portfolio would have produced also about 80% a year?.

Thanks.
buffetteer17
Buffetteer17 premium member - 10 years ago
Interesting question. A quick and dirty calculation gives 56%/year. The magic formula did a lot better. Scenario is to buy Jan 2009 call options on the S&P 500 index that are about $300 in the money, once a month for the past 8 months. You're getting a leverage factor of about 5x, far higher than you could ever get with margin loans, but of course, you're paying a time premium, trading costs, and spread costs. Remember, the big outfits who buy and sell these options aren't taking a loss long term.

The price today of a $1200 Jan 2009 call option on the S&P 500 index is about $430. This breaks down to a time premium of $107 and an intrinsic value of $323. In a year, about 1/3 of the premium disappears. There's enough data here for you do to the math. Note that the S&P 500 has gone from 1336 to 1523, a rise of 187 over the past 8 months. This is unusually good.
buffetteer17
Buffetteer17 premium member - 9 years ago
The experiment after 11 months

8/10/07 7/13/07

stocks -3.6% 23.7%

options 30.0% 85.2%

S&P 500 8.0% 20.9%

I thought it would be interesting to see how the Magic Formula Options portfolio did during bad times. It has given up 2/3 of it's gains, but is still earning a respectable 30%/year. I figured the leverage of options would really cause it to tank. I'm considering starting a real money Magic Formula Options portfolio, with some S&P 500 index puts included to hedge against bad markets.
Hari Chevali
Hari Chevali - 9 years ago    Report SPAM
Consistency is for the unimaginatives!
sgf
Sgf - 8 years ago    Report SPAM
Buffeteer17,

How do you purchase the options? the MF doesn't give you a target price.

-sgf
batbeer2
Batbeer2 premium member - 8 years ago
There is NO formula that works, sorry to burst your bubble....

I don't know about that. There are formulas based on price and there are formulas based on value.....

To put it another way, you need formulas to calculate an estimate of intrinsic value. The formulas are simple but they are formulas none the less. For what I know, the magic formula is based on (the change of) intrinsic value. Or simply growth.

Most gurus since Philip Fischer look at more than numbers but some very succesfull investors just stuck with the numbers and actually ignored management and other factors. Schloss to name one. They just use a huge margin of safety with sufficient diversification.

Like Berkowitz says, there are many ways to skin a cat.
tutihuti
Tutihuti - 8 years ago    Report SPAM
My fake money magic formula stocks are down 47% in about a year. S&P 500 did better. Unless you like to mess with stocks for pleasure, S&P 500 is the king. Asset allocation is far more important over time than what specific stocks you buy. When stocks get expensive you buy bonds such as late '90s. Now stocks are getting cheap you buy stocks such as SP 500. Vanguard charges only .18%.

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