Joel Greenblatt (Trades, Portfolio) is the managing director of hedge fund Gotham Asset Management and the author of "The Little Book That Beats The Market." He is well known as a popularizer of value investing strategies, and in particular of his "Magic Formula," which is geared towards retail investors looking for a quantitative approach to value investing. In this interview, he explained why so many people don’t follow tried-and-tested approaches like his formula and end up underperforming the market.
Why don’t people follow the formula?
Greenblatt’s Magic Formula emphasises a number of elements in its stock-selection system. It looks for high earnings yield and high returns on capital and ranks companies by those criteria to screen for suitable candidates. The investor should then accumulate positions in 20 to 30 of the highest-ranked companies and rebalance their portfolio once a year. There are a number of other steps and considerations (such as excluding utility and financial stocks), but that is the general idea. Not all the companies will be winners (Greenblatt thinks it’s 50-60%), but on average the portfolio works out.
This quantitative, rules-based approach to investing is supposed to help retail investors and stop them from overthinking their process. However, many investors find it difficult to stick to a particular strategy, even when presented with backtested data that demonstrates its historical effectiveness. Why is that?
“The reason it really works is that it doesn’t always work. It’s really not that great a formula, in other words. There was a period during that great ten years [2000-2010] where you beat the market by over 14% a year, so you more than tripled your money during that ten years. But at the same time, there was a 34-month period and a non-overlapping 13-month period where you underperformed that market. So most people quit on a formula, or just any strategy that isn’t working. Most people just chase whatever did well last year, and you can’t really do that as a value investor. It doesn’t always work - you could go a long time not beating the market.
Everyone would follow the formula if it was perfect, and there are years where it doesn’t work, and that’s when people stop following it. It’s hard to do, because if you look at the list of companies that it tells you to buy, you’ll see them in the paper and say “I don’t want to buy any of these things”. And some of them don’t work, but on average they do, because you’re not paying a lot for them and the ones that work out work out quite well.”
So it comes down to two things: short-term thinking and a psychological aversion to trusting the numbers. It’s one thing to rationally understand that sometimes your strategy will underperform the market (especially in times of excessive exuberance); it’s quite another thing to sit and wait while your peers are making money hand over fist.
Disclosure: The author owns no stocks mentioned.
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