Shorting The Magic Formula

 |  Includes: DIA, QQQ, SPY
by: Alpha Architect

I just got back from the Value Investing Congress. The event was exceptional and very thought-provoking.

While Einhorn's annihilation of Green Mountain Coffee was impressive (here is Einhorn's theme song), and Whitney Tilson's outline of the opportunity in Berkshire Hathaway was compelling, the speaker that I enjoyed most was Joel Greenblatt.

Joel's content was certainly not new and/or interesting to me, however, the audience's reactions and questions were entertaining. I'll summarize (gross approximation) the conversation between Joel and the audience:

Joel: "Quantitative value investing is a compelling way to earn solid returns and deploy large amounts of capital in a cost-effective manner"

Audience: "But Joel, the top decile for the Magic Formula's returns are around 15%, which are better than 95% of our returns. Are you suggesting that all of us who paid $2,400 for the conference and have spent our lives picking stocks are wasting our time?"
Joel: "Yes, exactly"

Interestingly, during the coffee break Joel passed by our table with a gaggle of groupies. The conversation we overheard went like this:

Groupie 1: "Joel, why not do the Magic Formula on the short-side? This seems like a compelling opportunity!"

Joel: "Because you will go broke."

"Because you will go broke"

What does Joel mean by "because you'll go broke?" First, a graph from our backtesting module on Turnkey Analyst. This chart shows the performance of the top 10% magic formula stocks and the bottom 10% magic formula stocks from Jan 1998--Dec 2002. You'll notice an ugly spread at the height of the internet bubble.

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Let's dig a littler deeper in to the performance of the magic formula long/short:

First, how about some basics (CAGR, vol, alpha, beta exposures, etc.) (click to enlarge charts):

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Okay, so things look kinda pretty from that angle: 5-10% annual alpha, negative beta exposure, and a decent 10% CAGR. A theoretical dream asset for a pension fund looking for an instrument with negative beta, but positive return!

How about the cumulative return chart?

HOLY SNIKES. This is Bill Miller deja vu! For almost 30 years a L/S magic formula investor would have enjoyed one of the more admirable track records known to the investment world--a Jim Simmons in the making. But when '99 comes around it is almost entirely erased--incredible, fascinating, scary, and downright heart-pounding.

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Just how bad is the drawdown during the internet bubble?

How about -86% bad!

The drawdown runs from Sept 98--Feb 00.

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So let's put the L/S in perspective. L/S is all about risk management: -86% is not risk management.

Lesson learned:
When Joel Greenblatt says, "Because you'll go broke," now you'll know why! Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.