Dealing With The Ups And Downs Of Joel Greenblatt's Magic Formula

One of the arduous challenges faced by investors is dealing with periods of underperformance. Different investing styles tend to suit different market conditions. So it doesn’t matter what the strategy is, there’ll always be times when it just doesn’t work. For those with a preference for a certain style, the discipline is in staying the course and sticking with the rules.

Few will know this better than followers of Joel Greenblatt’s Magic Formula. Greenblatt, an American fund manager, is behind a strategy that uses a simple combination of value and quality in its search for winners. It looks for good businesses at bargain prices, which Greenblatt claims “is the secret to making lots of money” (in his book, The Little Book that Beats the Market).

The trouble is that even cheaply priced, good stocks don’t always perform well as a whole in the stock market. For instance, investors in US markets have found in recent years that very expensive growth stocks can stay popular for a surprisingly long time. In these phases, nobody wants to buy value stocks, no matter how good they are. And even when value does come into fashion there are times when individual shares simply implode. And that's exactly what we saw this week...

How the tide turned for the Magic Formula

Last December I wrote about the fact that Stockopedia’s tracking of a screen inspired by the Magic Formula was on a bit of a roll. It’s gone on to rocket during the past six months. Joel Greenblatt said that despite the down years the strategy would outperform - and it seems to be doing just that. Except...

Take a look at that chart and it’s quite clear that an impressive run over the past year has ground to a halt. To be fair, equities have drifted during June and July, so some slowdown might be expected. But the last week has been terrible, and there’s a good (well bad, really) reason for that - Carillion (OTCPK:CIOIF) (OTCPK:CIOIY).

Carillion just missed out on being brought into the Magic Formula folio at the end of March, but made the grade for the June rebalancing two weeks ago. Unfortunately, Carillion’s massive profit warning this week means the portfolio is sitting on a 70% loss on that position.

Now, hypothetically speaking, if the Guru Strategies applied the conclusions of Stockopedia’s Profit Warning research from 2016, that holding in Carillion would have been sold on the day of the warning, stemming the loss immediately. But those aren’t the rules - Carillion stays in the folio at least until the end of September.

Learning the lessons

In the immediate aftermath of this setback for the Magic Formula folio, there are two lessons for onlookers. The first is that a systematic quality + value strategy like the Magic Formula will always be prone to individual disasters like this - it’s in its nature.

The strategy uses just two ratios: the earnings yield as a measure of ‘cheapness’ and return on capital as a measure of ‘quality’. It ranks the market from high to low for each measure and adds the two ranks together to come up with a ‘Magic Formula’ score for each company. Greenblatt himself said that Magic Formula stocks would deter many. They’d be unloved, misunderstood, occasionally debt laden or with broken business models. Carillion certainly passed some of those tests, but it scored well against the Magic Formula rules, and it still does.

But the Magic Formula’s vulnerability is also its strength. Because the strategy uses ranking in the market, there is always a list of stocks available. It simply takes those with the best blend of quality and value (according it its rules). That means the portfolio always contains a well-diversified 24-25 positions. It’s not like some of the growth strategies that really struggle for numbers in certain market conditions. The Magic Formula demands diversification, and that has really saved it from serious damage with Carillion.

This is no magic wand

Overall then, it’s frustrating to see the Magic Formula hit a single-stock collapse with Carillion. After a couple of years in the wilderness, the past 12 months have seen some strong returns from the portfolio - and it’s still up nearly 33% over that time. But it’s a reminder of the susceptibility of systematic value strategies. This approach deliberately doesn’t go looking for balance sheet black holes or pension deficits. Yet, its acceptance of these disappointments is managed through diversification. With strength in numbers, episodes like Carillion will hurt but they won’t be catastrophic.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.