Joel Greenblatt's Magic Formula

Introducing Greenblatt

I am keen to kick on and set out my investment manifesto. However, before we get to that I need to provide some more context.

Like musicians, investors are influenced by the greats that have come before them. Joel Greenblatt was influenced Warren Buffett who in turn was influenced by Ben Graham. From my first two posts you've probably guessed that I am a fan of Warren Buffett. Show me a private investor who isn't?

However, for me Joel Greenblatt is my single biggest influence.

The Little Book that Beats the Market 

Greenblatt's The Little Book that Beats the Market sets out in layman's terms the investment philosophy he used when running the hedge fund, Gotham Capital. Apart for being short (less than 150 pages), its written in a 'self help' style, full of whimsical anecdotes, like those self help books written in the 1930s by the likes of Dale Carnegie and Napoleon Hill.

Although a bit annoying in parts, Greenblatt does a good job of getting across the point that successful investing boils down to basic principles and discipline. In essence the advice is to buy great companies at bargain prices. While those words could have come straight from the mouth of Buffett, what Greenblatt does is to set out a mechanical approach for selecting stocks and managing a portfolio.

He selects stocks based on something he calls his  "Magic Formula". In very simple terms he uses earning yield as a  measure of value and return on capital employed (ROCE) as his measure of 'quality'. He ranks the universe of investable stocks on each these criteria and then adds them together. Stocks are then selected from the thirty or so lowest scoring stocks.

There is a good summary of "Magic Formula Investing" over on Stockopedia if you want to read more.

Does the Magic Formula work?

Greenblatt claimed that the MF is capable of making abnormal returns of up to 30% pa. However, independent testing has struggled to get anywhere near that. For example, over at Stockopedia the performance of Greenblatt MF screen has struggled to keep up with the FTSE 100, and currently ranks 50 out of 60 'guru' screens in terms of annualised performance.

There are a number of theories for this. Something I read a while back on a U.S. blog is that in recent years the MF has tended to flag up Chinese reverse take-over stocks that have mostly tanked. Ed Croft of Stockopedia has documented research by Wes Gray and Tobias Carlisle that suggests that the MF has a tendency to systematically overpay for quality. My own theory is something actually mentioned in the foreword of "TLBtBtM", which is: if lots of people start following a certain investment strategy then returns will diminish. I think that simplest explanations are most usually correct.

The MF is certainly the best known systematic/mechanical strategy around although I have no idea how many people are actually using it. I subscribe to a Yahoo group on MF Investing and if the recent postings, or rather lack of them, are anything to go by then it certainly seems like interest in the MF is waning.

Greenblatt himself says that the MF goes through phases when it doesn't work as well and that the trick is to be patient and wait for the inevitable upturn in performance. Interestingly, the Greenblatt MF screen on Stockopedia has had a bit of a surge recently increasing 14 per cent in the past 3 months. So, perhaps investors have given up on MF investing at just the wrong time?

Trust the Quant

Although I am inspired by Greenblatt I have reached the conclusion that his approach is not for me. First of all, I don't believe that following a well trodden path is an optimal strategy - its got to be better to seek an angle that fewer people are following.

Secondly, it seems to me that there has got to be better ways of identifying cheap stocks at good prices". Stockopedia have developed a more sophisticated approach for ranking stocks in terms of value and quality. For example, their method for ranking value uses earning yield with five other valuation metrics. That has got to give better results than just one.

However, the thing I do like about Greenblatt are the wonderfully simple things he has to say about mechanical investing. The idea of buying a stock and holding it for a year, The idea of buying and selling just once a quarter. The idea of selecting candidate stocks at random, rather than trying to apply additional discriminatory criteria. His overriding philosophy is to "trust the quant".

This is such a great mantra. My worst decisions always seem to be when I am panicked or acting impulsively. Learning to "trust the quant" is a way of allowing the intellect to subjugate those emotions that make us do stupid things. It is something I should start repeating to myself everyday!