Be A Value Investor Without Doing The Work: The Magic Formula

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Includes: CBI, EBIX, GME, HLF, KING
by: Inner Scorecard

Summary

The Magic Formula from Joel Greenblatt's Little Book That Beats the Market sounds like a cheap gimmick, but is in fact a robust value investing strategy.

When individuals implement the Magic Formula in a disciplined way, they buy above-average companies at below-average prices, which is by definition value investing.

The only way to succeed with the Magic Formula is to avoid behavioral bias. That means following the strategy in a rote and mechanical way, with no tweaking.

You have to stick with it! Most investors can't, which is actually why the Magic Formula will continue to work.

Despite the recent availability of Magic Formula alternatives (including from Joel Greenblatt himself), the simple Magic Formula, applied strictly mechanically, remains compelling for disciplined long-term investors.

Do you want to be a value investor but have no idea how to read financial statements? Or maybe you just don't have the time to do your own proprietary research. Fear not! The Magic Formula will do it all for you.

OK - it all, down to the name of the strategy, sounds very, very suspicious. I know it turned me off immediately when I first saw it. It's the same reaction I had when I saw the title of Joel Greenblatt's book describing the Magic Formula, The Little Book That Beats the Market (or as it's now known, The Little Book That Still Beats the Market). It sounds almost as bad as his other big book, You Can Be a Stock Market Genius. (Of course, that book somehow managed to launch a fleet of a thousand hedge fund manager careers, after the same methods made Greenblatt many millions of dollars personally.)

But consider this. This stigma associated with the name the Magic Formula is actually a huge boon to anyone that cares to practice the Magic Formula!

To look at why, we need to go back to the very definition of what the Magic Formula is.

"The magic formula tries to buy those companies that provide the best combination of being both cheap and good."

- Joel Greenblatt, The Little Book That Still Beats the Market, Afterword to the 2010 Edition

As Joel Greenblatt said both in the book and in almost every interview since then, the Magic Formula is a thought experiment - what results would you get if you tried to buy stocks that were cheap, Benjamin Graham style, but also good, Warren Buffett style?

As the Magic Formula is an abstract thought experiment, the parameters of "cheap" and "good" are both simplified.

"Cheap" is taken to mean that a company, compared to other companies, trades at a price that is cheap price compared to its earnings. But instead of using the simple price to earnings ratio, Joel Greenblatt's Magic Formula instead uses the adjusted metric of EBIT/Enterprise Value.

"Good" is taken to mean that a company, compared to other companies, can reinvest its money at higher rates of return. The adjusted metric that the Magic Formula uses to calculate this is EBIT/(Net Working Capital + Net Fixed Assets).

The Magic Formula ranks the stocks in the market by how cheap they are, ranks them by how good they are, and then combines these rankings to get an ordering of how cheap and good each stock is.

Put even more simply, the Magic Formula is a way to systematically buy companies that are priced at less than they are worth. That's value investing. The good thing about the Magic Formula is that it does this for you.

Even better, you don't actually have to run the screens yourself (although you can if you want to). Just go to magicformulainvesting.com/, create a free account, and the computer will spit out a list of stocks (US stocks excluding ADRs and financial and utilities stocks, for which it is not appropriate to use the Magic Formula criterion) for you. You then simply buy a few stocks from this list every month, and hold each stock for about a year (give or take a day for tax-loss harvesting). That's how little work you need to put in this.

Oh? And the returns...they're quite good.

In The Little Book That Still Beats the Market, Joel Greenblatt reported that the Magic Formula applied to stocks over $50 million from 1988 to 2009 returned a total of 23.8% annualized. By comparison, the S&P returned a total of 9.5% annualized over that same period. You can see the performance of the Magic Formula since then at third-party sites unconnected with Joel Greenblatt (so the methodology in calculating return - which is complex, may not be exactly the same).

But this article won't focus on the returns. If you want to research those, there are a lot of third-party sources that let you look into more details on that. This is an article on how to be a value investor by using the Magic Formula. And being a value investor is about having the correct process, not on chasing recent good performance.

So if the Magic Formula is so great, why hasn't everyone done it? What is it about the process that makes it so good, and yet so rare? And we all know that one of the iron rules of finance is that good ideas tend to be arbitraged away. Why hasn't the Magic Formula suffered the same fate?

A few reasons:

1. The stocks that the Magic Formula highlights tend to be cheap for obvious reasons. Many are heavily shorted and hated. Stocks that are cheap despite being quantitatively good tend to be so because of serious headline risk or other "ick" factors.

2. The Magic Formula works for the same reason that value investing itself works - that is to say, it doesn't work all the time and it takes time, and in today's impatient and recent-past-performance oriented market, this opportunity does not get fully arbitraged away. And the results are quite volatile. There will be many down months and in fact many down years and many months and years of underperformance as well.

3. The Magic Formula is robust, meaning that not only does the top ten percent of stocks as ranked by the Magic Formula outperform the other stocks, but the second best ten percent performs all the ones below it, the third best ten percent performs all the ones below it in turn, and so on, to the very worst ten percent. So it is naturally hard to arbitrage away.

4. It's very unsexy. You won't impress any of your friends by saying you beat the market by mechanically applying someone else's formula from a book published in 2010. You won't get a job in equity research or as a hedge fund analyst by talking about your personal portfolio which was invested mechanically in the Magic Formula.

5. And most importantly, going back to the original point - the very name of the Magic Formula is repellent to people! And the process is, too. People either want to use their judgment to pick stocks, or they want to just set and forget a regular monthly contribution to a fixed asset allocation across index funds. So the Magic Formula will never catch on. The whole thing has an ick factor. And that's very beneficial to people who actually stick with it. The less people do it, the stronger it is.

But although it works, you don't hear a lot of stories of people getting rich with the Magic Formula. Why?

The strongest reason is our human behavioral flaws. There's something weird about the human tendency to ruin a good thing. Tobias Carlisle and Wesley Gray wrote about a strange phenomenon in their recent book Quantitative Value. Study after study in fields as different from finance as medical diagnosis have shown that even expert judgment tends to detract from the performance of a good model. That is to say, models do worse when you add human judgment, even if it's the judgment of an expert! The same is true in investing, and especially so for the Magic Formula. Joel Greenblatt said it himself in an online column (referring to an experiment where a partner company set up accounts to let people either pick Magic Formula stocks themselves out of a defined list, or just do the picking for them, randomly):

Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn't do too badly. A compilation of all self-managed accounts for the two year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.

"Hmmm....that's interesting", you say (or I'll say it for you, it works either way), "so how did the 'professionally managed' accounts do during the same period?" Well, a compilation of all the "professionally managed" accounts earned 84.1% after all expenses over the same two years, beating the "self managed" by almost 25% (and the S&P by well over 20%). For just a two year period, that's a huge difference! It's especially huge since both "self-managed" and "professionally managed" chose investments from the same list of stocks and supposedly followed the same basic game plan.

Let's put it another way: on average the people who "self-managed" their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!

- Joel Greenblatt, 2012

What tends to happen is this. The Magic Formula will give you a list of stocks to choose from. Most people will exercise their judgment and pick the stocks that look the safest or the most promising out of the list. They'll purposely avoid the ugliest looking companies that they just know will lose money.

And what will happen is that the stocks that tended to look the best will actually perform the worst, and the stocks that looked the worst will perform the best.

And by doing so, they'll drain all the outperformance out of the Magic Formula, and in fact end up not even performing as well as if they had simply bought an index fund!

So I can say with certainty that you shouldn't do that.

I can give some personal examples out of my own Magic Formula portfolio.

Chicago Bridge & Iron (NYSE:CBI) looked like a great pick when I bought it in July 2014. (I exercised no judgment when I bought the stock. I bought it because it showed up on the relevant Magic Formula list for me.) It was a big holding at Berkshire Hathaway for good measure, picked either by Warren Buffett himself, or Ted Weschler or Todd Combs. One of those super stock pickers had decided this was a great stock to own. Even H. Kevin Byun of Denali Investors, one of Joel Greenblatt's best students, was behind this stock!

As of the writing of this article, it's down over 30% from my cost basis, excluding dividends. And it could turn out to be a permanent impairment of capital, depending on what happens in the world.

On the other hand, Ebix (NASDAQ:EBIX) looked like a terrible pick when I bought it in August 2014 (Again, I exercised no discretion in picking the stock, but bought it merely because it showed up on the Magic Formula list.) The stock was extremely heavily shorted, and I think I had to put in a special verification code at my broker when buying it, so heavy was the stigma.

As of the writing of this article, it's up over 45% from my cost basis, excluding dividends, and could go higher still.

A few tips for implementing the Magic Formula without style drift due to behavioral error:

1. Decide on a fixed asset allocation to the Magic Formula, and then stick with it, by putting the same dollar amount into the Magic Formula every month. Don't chase returns by putting money in when the Magic Formula has done well in the last few months, and then not putting money in when the Magic Formula underperforms the market. Beware of self-deception in coming up with reasons not to stick to the exact rules.

2. Don't time the market. Concretely, this means making your contributions regularly rather than according to your whim or any other market-timing factors. And it also means sticking to the rules of holding each stock for one year (give or take one day, for tax-loss harvesting purposes), no more, no less, regardless of how good or bad the stock looks at any given point of time during your holding period.

3. Pick stocks completely randomly from the Magic Formula list, and resist the urge to "just this once" selectively buy or not buy a stock, no matter how great your knowledge on that specific company. This goes back to the point expressed in Quantitative Value about even experts detracting rather than adding value to a good model, which is what the Magic Formula is.

The last point is the most important, and the hardest to stick with. You will end up buying a lot of stocks that look like value traps, and a lot of those stocks will in fact be value traps. My portfolio currently has Gamestop (NYSE:GME), among other companies that everyone knows are obsolete, Herbalife (NYSE:HLF), among other companies that everyone knows are "frauds" and King Digital Entertainment (BATS:KING), among other companies that everyone knows have past earnings that are unsustainable in the future. All of these stocks may in fact end up as losses. But implementing the Magic Formula means trusting that on the whole, taken across a diversified portfolio of Magic Formula stocks, and over a long period of time, because of the systematic underpricing by the market of these statistically cheap and good companies, the losers will be made up for by the winners. And because we trust in the power of a proven model over human judgment, which we know to be flawed, we know that throwing out or throwing in stocks to your Magic Formula portfolio will on the whole detract from the portfolio's returns.

The easiest way to fail, and ironically what happens to almost everyone who tries the Magic Formula, is that they just cannot stick with it in a systematic way (just Google "Magic Formula blog." You'll find many who a retail investor who tried to be a Magic Formula investor but just could not stick with it or ended up making their own little tweaks that killed their returns).

In fact, the failure rate was so high that Joel Greenblatt - who doesn't exactly need the money after making millions as a special situations hedge fund manager - opened a set of mutual funds called the Formula Funds that did the Magic Formula for you. But then that didn't work out either because people could not handle the volatility. So then he closed those funds and opened a series of mutual funds called the Gotham Funds that do a sort of modified Magic Formula, but that short expensive stocks as well to lower the volatility. You can invest in those if you'd like. But to be honest, the fees are pretty high. And if you can handle volatility, you should just do the Magic Formula by yourself. After all, Joel Greenblatt keeps on paying the hosting fees for magicformulainvesting.com/, and keeps on standing by the Magic Formula in interviews. And if you want to hedge your market exposure, you can always just buy S&P 500 put options or futures.

So although the secret is out, it's as if it isn't. After all, value investing itself hasn't exactly been a secret for a very long time, and yet it continues to work. So if you are the rare person who can stick to the Magic Formula, you will end up beating the market over the long run. That's what will happen if you buy stocks that are both cheaper than the market and better than the market.

That's what long-term value investing is. Sticking to a process that you know works. And the process here intuitively makes sense. By following the Magic Formula, you are basically making your own mini index fund. But it's better than a typical market-capitalization-weighted index fund that you might buy from Vanguard. Instead of being weighted towards the biggest companies, which may be overpriced compared to their intrinsic value, your mini-index fund that is your Magic Formula asset allocation is equally weighted among a set of companies that are both the cheapest and the best. You can't not do better than the market in the long run (although you will have months and years of underperformance which cause most people to quit, and thus which allow the anomaly to continue to exist) with such an approach. You are buying better businesses that are also cheaper. And if you believe in the principles of value investing, you know that the return from investing comes from a combination of the underlying businesses you buy and the prices you pay for them. So you will beat the market, and you will do it by value investing. Yet somehow, you can avoid doing any of the hard work usually involved.

Just don't talk about it to your friends, family, and on forums. You'll be derided for using a "Magic Formula" and reading a "Little Book That Beats the Market." But that's good. It means less competition for you, and that's why the Magic Formula will continue to be a compelling investment methodology going forward.

P.S.

One downside of using magicformulainvesting.com/, which is after all free, is that the site does not retain historical data. Thankfully, some third parties have stepped up that task. The best I've seen are www.magicdiligence.com/, which provides summaries of the Magic Formula's performance each year since 2009, so you can see how the Magic Formula performed since the book's publication, and www.dusthimer.net/Magic-Formula-Data.html, which has collected the monthly Magic Formula picks as reported by the website, so you can play around with the data yourself.

But I personally don't recommend playing around with the data too much here. You'll get tempted to add a variable or ten and ruin a simple good thing, as most have.

Disclosure: The author is long CBI, EBIX, GME, HLF, KING.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author's personal portfolio has a substantial portion allocated to a strictly mechanical Magic Formula strategy.