Every investor wants to beat the market and a vast number of strategies and systems have been developed in the effort to achieve that goal. But the goal has always been elusive. Even tried and tested strategies like value investing (a blanket term that incorporates a wide variety of sub-strategies and techniques) have sometimes failed to net the market-beating returns investors crave, especially during sustained bull markets where nothing seems cheap.
Some strategies prove to be little more than short-lived fads, while others stand the test of time. The movement of market-tracking ETFs from niche to mainstream in recent years is proof of one such recent shift in the popular investing wisdom.
Introducing the magic formula
Joel Greenblatt (Trades, Portfolio), an academic and hedge fund manager, introduced his magic formula in 2005 when he published "The Little Book That Beats the Market." The magic formula is designed to automate and systematize investing decisions to create a hybrid “quantitative value investing” strategy that can beat the S&P 500 and other index benchmarks.
The key features of this strategy are not terribly complex, making the programmatic elements of employing the system quite straightforward:
- Good companies = High return on capital (ROC defined as operating profit divided by net working capital plus net fixed assets).
- Cheap stocks = High earnings yield (earnings yield defined as pre-tax operating earnings divided by enterprise value).
- ROC = EBIT/(net working capital + net fixed assets).
- Earnings yield = EBIT/(enterprise value).
- If net working capital is negative, use zero.
- Here, EBIT is last 12-months' earnings before interests and taxes (EBIT).
The magic formula is concerned with two types of returns:
- The return to the investor based on the price they paid for the company’s stock.
- The return to the company based on capital invested.
Certainly, there can be little case to fault a value investing strategy that focuses on finding good companies with cheap stocks that are consistently producing high returns on capital and strong earnings yields. But does the magic formula work in practice?
A not-so-magical track record
It is far easier to say a strategy will deliver consistent high performance than to prove that it will. When Greenblatt published his book in 2005, he reported that the magic formula investing had delivered an average annual return of 30.8% over 17 years and that it beat the S&P 500 96% of the time.
Those are enviable numbers, but do they hold up over time?
Unfortunately, a strategy based on an equal-weight portfolio of 30 stocks rebalanced annually may not always produce optimal results. Since 2005, Greenblatt’s formula appears to have lost some of its magic – or at least some of its former consistency. From the linked article:
"In 2009 Greenblatt relaunched his company as Gotham Asset Management, which he runs together with Robert Goldstein. In 2012 the firm launched a series of long/short mutual funds to complement its hedge funds. The firm’s most recently launched fund, the Gotham Index Plus fund, combines active and passive investment strategies. In 2016 the fund outperformed 95% of its peers.
However, Gotham’s funds have had mixed results since 2012. Value investing has fallen out of favor, and returns for long-short funds have been hurt by the performance of short positions. In 2015, all the funds lost money and underperformed their benchmarks, resulting in withdrawals. The funds have since recovered and as of 2017, the firm has $11.6 billion under management."
But 2017 was not a great year for the magic formula; the portfolio frequently tipped into the red even as the broader stock market enjoyed a sustained bull run.
What does it all mean?
Ultimately, the magic formula has underperformed due to a number of factors. Perhaps chief among them is the general market climate, which has soured on value investing during the course of the nine-year bull market. Almost everything can look expensive to a value investor these days, and many investors and large-scale allocators have turned to growth stocks, foreign markets and alternative asset classes in a desperate hunt for yield.
Even so, good companies should not see deterioration during a bull market, generally speaking. While some stocks may underperform and be weeded out in a rebalance, the more general malaise around the magic formula investing portfolio suggests that there might be other factors at play in addition to the broadly unfavorable market sentiment.
Part of the problem may be the over-systematized nature of the magic formula. We have written before about the problems inherent in using screeners to automate investing decisions, especially when looking for cheap stocks. Over-automation can lead to laziness and complacency, and may result in sub-optimal decision-making – especially in the event of rapid changes in market conditions or other shocks.
In our own portfolio management operations, we use screeners somewhat sparingly. They add value sometimes by shaking loose interesting value or opportunistic plays that might otherwise have remained hidden. But they should not guide investing strategy.
Disclosure: I/We own no stocks discussed in this article.