Joel Greenblatt (Trades, Portfolio) argued that his Magic Formula would beat the market. And, it did. Using a strategy akin to Warren Buffett (Trades, Portfolio)’s “wonderful companies at fair prices,” Greenblatt used a combination of return on capital and earnings yield to rate individual stocks against each other. Those with the best combined scores would be the best investment candidates. Based on backtesting, Greenblatt showed his model could more than double the returns of the S&P 500 over the 17 years he examined.
Tobias Carlisle reported he generated similar results in research undertaken for his book "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market"; he tested the Magic Formula over a longer period, 44 years.
But Carlisle wasn’t simply trying to replicate Greenblatt’s work—he was aiming to go one better by building on the work of Benjamin Graham, Buffett and Greenblatt. Carlisle had developed a different strategy, or theory, based on enterprise value and operating earnings, a test of the ideas of Graham and the young Buffett. That model might be summarized as “fair companies at wonderful prices.”
In 2017, Carlisle commissioned an independent study to compare the returns of the Acquirer’s Multiple and the Magic Formula. The research firm used a simulated portfolio of 30 stocks, covering the years between 1972 and 2017. The testing was divided into three universes, and these were the results (in average annual returns):
- $50 million minimum market cap: Magic Formula 16.2%, Acquirer’s Multiple 18.6%.
- $200 million minimum market cap: Magic Formula 17.2%, Acquirer’s Multiple 17.5%.
- $1 billion minimum market cap: Magic Formula 16.2%, Acquirer’s Multiple 17.9%.
The Acquirer’s Multiple, then, beat the Magic Formula by 0.3% to 2.4% in each of the universes and, of course, they both beat the S&P 500 by significant margins. The Magic Formula had averaged annual returns of better than 30% in Greenblatt’s original testing, as he had reported in 2006. Although Carlisle does not explain the difference between the results in the original testing and his testing, it may be attributable to the longer period, which included crashes in 1974 and 2008.
Why did the Acquirer’s Multiple beat the Magic Formula? Because of mean reversion, an issue Carlisle had discussed in a previous chapter. He argued that choosing stocks based on their historical profitability reduced returns.
To test this theory, he created a new portfolio called the “Poor Charlie,” in recognition of the character in Charlie Munger (Trades, Portfolio)’s book, “Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger.” This hypothetical character created a portfolio made up of the 30 stocks with the highest profits, regardless of their value. Each of the three universes outperformed the market, but did not outperform the Magic Formula or the Acquirer’s Multiple.
Carlisle was able to cite another couple of independent pieces of research to confirm his results. But most importantly, he found support in an early article by Greenblatt. In 1976, at age 19, Greenblatt first heard about Graham and was immediately attracted to his ideas.
What he learned was from an interview Graham did with Forbes Magazine a few months before his death in 1976. Graham told the interviewer that he did not want complicated methods of valuing stocks. Instead, he emphasized what we know as “cigar-butt” investing, buying stocks that had more cash and liquid assets than debt, so long as those stocks were selling a significant discount to their net value. He called the strategy “foolproof” and “unfailingly dependable.”
A couple of years later, when Greenblatt was attending Wharton, he and two classmates decided to dig more deeply. Using data from old Standard and Poor’s stock guides (printed version only), they assembled a list of about 750 stocks that were available between 1972 and 1978, a period that included the market crash of 1974.
The trio published their findings in the Journal of Portfolio Management in 1981, under the title “How the Small Investor Can Beat the Market.” What they found was proof of Graham’s idea that a cigar-butt strategy soundly beat the market—by more than 10% per year. It was support for the theory that “fair companies at wonderful prices” was a winning strategy.
At the State University of New York, Henry Oppenheimer confirmed what Greenblatt and associates had found, that the cigar-butt strategy beat the market. He also took the issue three steps further, first by dividing the stocks into five groups, most undervalued to least undervalued. The most undervalued group beat the next group, and so on. Conclusion: The more undervalued the stocks, the more likely they are to have the better return.
Second, Oppenheimer divided the stocks into a group of profitable stocks and a group of stocks with negative earnings. Surprisingly, the loss-making stocks outperformed the profitable stocks. The third test saw him divide the stocks into a group that paid dividends and a group that did not. It turned out the non-dividend payers had higher returns that those that did.
Carlisle summed up the work so far as:
“The key to maximizing returns is to maximize our chance at mean reversion. That means maximizing the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert.”
In his book “Security Analysis,” Graham observed the three most important words in investing were “margin of safety." And he offered three rules for setting a margin of safety:
- The larger the discount to value, the greater the margin of safety, and the wider the discount, the more allowance for errors in calculation and other mistakes.
- Look for the margin of safety in the balance sheet. There must be more cash than debt.
- The company should be a real business with historically good operating earnings and cash flow, to avoid the embezzlers and fraudsters.
Carlisle concluded chapter 7 with: “weak current profits in a stock with a good past record creates a good chance for deep-value contrarians to zig."
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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