This article on Joel Greenblatt's magic formula was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Alexas_Fotos, edited by The Broken Leg.
Things Tend To Get Easier, So Why Shouldn’t Benjamin Graham-Style Investing?
Over time, things tend to get better and easier. Economies, technology, standards of living, food quality, video game graphics — the list goes on and on. If it is therefore a fact that as time passes and we learn more, humans improve at “things.” Why would investing be any different?
This is the question that Joel Greenblatt no doubt posited when he wrote the book The Little Book That Beats The Market. Benjamin Graham became the father of investing when he wrote The Intelligent Investor, providing a definitive and quantitative strategy for targeting undervalued companies. The Little Book That Beats The Market, with a Charlie Munger-esque approach, aimed to build upon this original formula by combining the idea of “value” with that of “quality.” Using Earnings Yield (EV/EBIT) as a proxy for value and Return on Invested Capital (ROIC) as a proxy for quality, Greenblatt sought to outperform the market and thus prove the validity of his formula — which he named “The Magic Formula." Tobias Carlisle, in his book Deep Value, discusses Greenblatt’s results:
“Over the 17 years tested from 1988 to 2004, portfolios of 30 stocks with the best combination of earnings yield and return on capital would have returned 30.8 percent per year. To put this in context, wrote Greenblatt, investing at 30.8 percent per year for 17 years would have turned $11,000 into well over $1 million. Over the same period, the market returned just 12.4 percent per year, which would have turned the same $11,000 into just $79,000. Further, Greenblatt found that his portfolios generated those returns while taking much less risk than the overall market… The three computer simulations of Greenblatt’s quantified and simplified version of Buffett’s ‘wonderful company at a fair price’ investment strategy suggested that it would have substantially beaten the market, and done so with less risk.”
Benjamin Graham's Magic Formula: Time To Move On?
In the early years of his investing career and during the years that he ran his partnership, Warren Buffett, originally a student of Benjamin Graham, stayed loyal to the fundamental value-investing principles of his mentor. Since then, and since he began to work with a man named Charlie Munger, his focus has shifted somewhat. What was originally a value-only approach (good companies at wonderful prices), now places a greater degree of importance on the quality of the company (wonderful companies at good prices).
This is exactly what Greenblatt sought to capture with the introduction of The Magic Formula. The earnings yield, a common metric used by acquiring companies, is commonly considered a far better measure of value than P/E ratio. ROIC, on the other hand, tells us how much the company is making in excess of its cost of capital. Combining the single best valuation and quality yardsticks, Greenblatt has seemingly managed to find a formula that might even top that of the great Benjamin Graham — and it makes perfect sense.
If we can identify both cheap and high-quality companies, then why wouldn’t we buy them over purely low-price ones? If you are in an Apple store and have the option of buying an iPhone 6 for $100, or an iPhone 7 for $105, are you not always going to choose the iPhone 7, ceteris paribus? Of course you are! This is because, while you’re paying slightly more, you know that the quality of the 7 exceeds that of the 6. The certainty of the additional quality warrants the higher selling price, yet it still feels like a bargain!
Greenblatt, with his Magic Formula, believes he has found the investing equivalent of the above scenario. If he is correct, he has essentially laid down the only blueprint that any value investor will ever need. If he is correct, we can forget about Benjamin Graham and his net-net investing, and anyone else who preaches about value investing. If Greenblatt is correct, and the Magic Formula does trump all other value investing strategies, we should all be rushing to the bookstore right now! Below, Carlisle further examines Greenblatt’s results, and whether all is truly as it seems.
Surely We Shouldn’t Just Forget About Benjamin Graham?!
“Eager to know, we devolved the Magic Formula into its constituent parts — return on capital and earnings yield — and tested each independently over the full data period. The results were, to say the least, a little surprising. In the United States over the period 1974 to 2011, the Magic Formula generated a compound annual growth rate of 13.94 percent, beating the market’s annual average of 10.46 percent. The earnings yield alone, however, earned 15.95 percent annually, while the return on capital measure earned just 10.37 percent annually. You read that right. The earnings yield alone beat out the Magic Formula, and the return on capital measure underperformed the market, dragging down the return to the Magic Formula with it… What does return on capital contribute to the Magic Formula? Startlingly, it seems to add little but poorer returns and elevated volatility.”
What Carlisle uncovered from Greenblatt’s research was quite amazing. Not only does the “quality” half of the Magic Formula not add value to the equation, but it actually deducts from it. In other words, the very attempt to add a definitive and quantitative measure of quality to one’s portfolio succeeds in achieving the exact opposite of what you hoped it would. These results are counterintuitive and beg the question, “Why does this occur?”
The reason, as was pointed out in an earlier article, is a little natural phenomenon known as mean reversion. Simply put, mean reversion assumes that a stock price will return to its long-term average over time. The way in which it operates is more straightforward from the value side of the equation. When a company’s earnings yield is low (say below 5), it can be considered undervalued.
Undervalued companies are often this way because of poor recent results or some other transitory event, e.g. the business cycle. As a result, it is liable to become shunned by investors. As its price gets bid down, its earnings yield falls too, and it becomes more undervalued. Inevitably, the original event that caused this price reduction reverses, and the stock price rises again.
Following the above thought process, it should begin to become clear to you why seeking a company with an already-high return on capital might, on average, reduce the returns that you enjoy on a portfolio of stocks. This is again because most companies are unable to resist the forces of mean reversion. Therefore, by targeting companies with high current rates of return, you are likely condemning your portfolio to limited performance over a period of time.
Benjamin Graham Has Never Been More Relevant
“Again, the evidence is compelling that the Magic Formula outperforms the market, but not because it identifies wonderful companies at fair prices. Wonderful companies, defined in this context as ones earning a high return on capital, reduce returns. The data suggest that the better bet is fair companies at wonderful prices. The why of it reveals two truths about value investment: First, Greenblatt’s earnings yield is a very good metric for identifying undervalued stocks, and, second, mean reversion is a powerful phenomenon.”
Almost no company has the ability or strength to withstand the powers of mean reversion. Someone who had the ability to identify such a company beforehand would be the only person who could justify using both aspects of the Magic Formula to make investment decisions. As it happens, there is only one such man in the world who has proven his ability over a great many years to consistently pick out these companies, and his name is Warren Buffett. Rather than referring to them as mean-reverting powers, Buffett calls these types of companies “castles with a moat” (the moat is the aspect/barrier of the establishment that prevents competitors from damaging it).
For the rest of us who do not possess Buffett’s gift, it seems that we should stick with pure value investing and not get greedy with our approach. The reality is that, whether the discussion is regarding qualitative or quantitative data, it is extremely difficult to predict the existence of moats before they appear. In conclusion, it might well be argued that there can indeed come a time when further improvements to human processes cease and those that already exist are as good as they will ever get. In the case of Benjamin Graham and his theories on value investing, this certainly appears to be one of those times.
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