When it comes to investing, should you opt for indexing, active investing or indexing the Greenblatt way? Author Mohnish Pabrai (Trades, Portfolio) came down squarely in the Greenblatt camp, as he explained in chapter 16 of “The Dhandho Investor: The Low-Risk Value Method to High Returns.”
The Dhandho way, in general, means finding investment opportunities that are low-risk with potentially high returns. He has also described it as “Heads, I win; tails, I don’t lose much.”
His starting point in this chapter was the difference between passive indexing and active management, the crux of it being frictional costs. He wrote, “Active managers have very real and significant frictional costs.” Those costs, including fees and commissions, are considered an anchor on good investing intentions. Value investors seek to minimize them.
Pabrai obviously prefers indexing to active management, at least for individual investors. He, of course, remained a stock-picking hedge fund manager. Within the universe of index funds, he thinks investors can do better than the average results generated by most broad index funds.
To provide more insight, he noted he was a fan of David Swensen (Trades, Portfolio) of the Yale endowment fund; Swenson became an all-star investor by generating an average annualized return of more than 16% per year for over 20 years. He did that by getting out of bonds and into private equity, hedge funds and concentrated value funds. He took an active approach, but recommended that individual investors stick to indexing.
Pabrai was an even bigger fan of Joel Greenblatt (Trades, Portfolio) and Greenblatt’s book, “The Little Book That Beats the Market” (and later, “The Little Book That Still Beats the Market”). In the two decades before Pabrai published his book, Greenblatt had delivered annual returns that averaged 40%.
Like Warren Buffett (Trades, Portfolio), Greenblatt’s performance dipped as his assets under management grew, but he was still beating the market when it went over a billion dollars. Buffett had averaged better than 20% per year in the five decades before the mid-2000s. At the core of “The Little Book That Beats the Market” is the Buffett-like idea of buying good businesses when they are cheap.
Greenblatt called his approach the “Magic Formula.” It was based on two lists of all available stocks. The first list rated stocks by their return on invested capital, to determine the quality of each stock. The second list was ranked by price-earnings ratio and gave a relative valuation for each stock. The two lists are then combined into a master list by adding the individual scores together for each stock (this is done automatically for visitors to Greenblatt’s free website).
The website will turn out a list of these “best” stocks at the click of a button. And, it is Greenblatt’s thesis that an investor could build her or his own outperforming portfolio with the top 25 or 30 of these stocks, saying “It trounces the S&P 500—with no thinking or analysis required.”
Pabrai called such a list of Magic Formula stocks “effectively an index. But it is the mother of all indexes—an index on steroids. I like to think of it as the Dhandho index.” He can call it an index because it operates with a set of fixed rules: Buy five to seven stocks every two to three months; for example, buying every two months would equate to six buys per year and six buys multiplied by five stocks per purchase would work out to 30 stocks per year.
After a stock has been in the portfolio for a year, it can be sold and replaced with another stock from the now-updated list. By making the investments at two- to three-month intervals, an investor is, in effect, dollar-cost averaging. Pabrai summarized, “because the buy and sell decisions for each stock are so rigid and mechanical, there is no room for our poorly adapted, fear- and greed-driven brains to mess up our equity investing results."
Pabrai’s book was published in 2007, and there is now a historical record of how Greenblatt’s Magic Formula strategy has worked since then. These are the results since 2006, according to market observer InvestorsEdge:
- 2007: 27.6%
- 2008: -43.8% (slightly worse than the S&P 500)
- 2009: 55.0%
- 2010: 19.4%
- 2011: -23.5%
- 2012: 0.9%
- 2013: 32.0%
- 2014: 0%
- 2015: 1.1%
- 2016: 2.6%
- 2017: -2.3%
- 2018: 3.5%
If you had taken Pabrai’s advice and invested using the Magic Formula, you would be justifiably dissatisfied. It indicates once again that while some strategies may deliver spectacular results for a few years, very few outperform in the long run.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- The Dhando Investor: Guidelines for Selling Stocks
- The Dhando Investor: Be a Copycat, Not an Innovator
- The Dhando Investor: Finding Low-Risk, High-Uncertainty Companies
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