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John Engle
Articles (258) 

Is This the Magic Formula of Value Investing?

This quantitative value system claims to beat the market

June 29, 2018

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.

Today, we look at one value-type strategy that beat the market for many years: Joel Greenblatt (Trades, Portfolio)’s Magic Formula Investing, which claims to beat the market consistently.

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:

  1. The return to the investor based on the price they paid for the company’s stock.
  2. 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.

About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

Rating: 4.3/5 (9 votes)



SciDeep premium member - 7 months ago

Thank you, John. Good article.

All time tested formulaes can be helpful as indicators, if one is well aware of the components within them. And wary of any 'constants' used as prefactors to fit past data (sometimes very old data). A fair number of these canned formulaes that are available in literature are used by GuruFocus. But as you say, they should not be used willy, nilly to make decisions. Unless specific ones meet an investors metrics for decisions. Recognizing that they may be sector and era specific. One should go back to the paper from where they originated to insure one understands their nuasances.

Continue good, informed investing. Cheers

Benlawson - 7 months ago    Report SPAM

Hi John, great article! "In 2015, all the funds lost money and underperformed their benchmarks, resulting in withdrawals". Does withdrawls affect the performance of a mutual fund?

LightChase1 - 5 months ago    Report SPAM

I did Magic Formula Investing for a couple of years. I consider myself an experienced investor. First, there is no quantitative way to validate Mr. Greenblatt's method. He does not provide entry/exit prices for his results, and the exact list of potential investable companies is almost infinitely differential. As degreed an academic as Mr. Greenblatt is, it's easy to make claims for spurts of time or for simulations that aren't quantifiable or comparable to a reference. I found that, in the end, I did better doing my own research as a stock picker with measurable filters I use for my own "system."

In truth, I've discovered that holding BRK-B/ QQQ/VIOV in a 5/2/1 ratio for 15 years or more along with short term CD's (forget bonds and bond funds in this interest rate environment), appropriate for one's age and market environment, are the highest returns possible in the long run.

Liamflavelle - 5 months ago    Report SPAM

I wrote a research article a couple of months ago with some research of how the Magic Formula has performed since its publication in 2005 - Has The Magic Formula Lost It's Sparkle?. You can see the performance of the model here:

magic formula equity curve

What I did find is that if you add criteria to only include stocks with a Piotroski F Score >= 6 and add 12 mths Trailing Yield as a ranking factor you can improve the performance:

Magic formula with Piotroski and Yield

Still not great but better than the original!

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