Magical, sure-fire way to make money just too good to be true?
A dozen years after being published, The Little Book that Beats the Market is still causing a stir
If someone offered you a magic formula for making “easy” money in the market, would you use it? Would you even bother to look at it? Or, would you look at it and try to improve on it? And what would that tell us about investors’ responses to a sure thing?
In The Little Book that Beats the Market, Joel Greenblatt promoted an investment strategy he called “the magic formula”. At the time of writing (the book was published in December 2005), Greenblatt claimed the formula beat the S&P 500 96% of the time with an average 17-year annual return of 30.8%, compared to the S&P’s 12.4%.
That would have turned $10,000 into $960,000, instead of $73,000, from 1998 to 2004.
This period included both the “internet bubble” and the market crash of 2000-02, and while the formula didn’t beat the index every year, it did so in any period lasting three years running or longer.
In 2009, John Reese, who tracks “guru strategies”, confirmed the magic formula had again beaten the market in each of the prior three years and continued to do so, “minimising losses in one of the worst market environments in history”.
The formula has only two inputs, a company’s earnings yield (ebit/enterprise value) and its return on capital (ebit/net fixed assets + working capital). It calls for a minimum market capitalisation, the exclusion of utilities and financial stocks, the ranking of companies by earnings yield and return on capital and investing in 20 to 30 of the highest-ranked companies by accumulating two to three positions a month over a 12-month period.
Thereafter, Greenblatt suggests rebalancing the portfolio every year by selling losers one week before the year mark and winners one week after; repeated over three to five years .
For those simply looking for investment “leads”, the formula can be made simpler by applying attributable income on equity to determine earnings “quality” and price-to-earnings ratios to identify relative cheapness. The rationale remains the same: identify shares in good businesses (measured by return on capital) when they are relatively cheap (reflected in a low p:e).
From its apparent success and easy application, it’s hard to imagine one would refuse to take a look at the formula. Greenblatt must have thought that would be the case when he wrote: “You're probably thinking it won’t work or it'll be too hard or there’s something wrong with a book that even claims to have a magic formula.”
“Too darn right,” says Nisiprius at Bogleheads.org. “I wouldn’t waste a minute on anything that uses the words magic formula. He doesn't have a magic formula and if he did he wouldn’t sell it for $13.57. Ask yourself, what does the word magic mean? It’s either the art of producing illusions as entertainment by the use of sleight of hand, deceptive devices, etc … or else it’s the use of techniques that presumably assure human control of supernatural agencies. In other words, it’s either a scam or a delusion.”
Other Bogleheads agree. However, like most things that work in the market, there is probably more common sense and discipline than magic behind Greenblatt’s approach.
As he says, “I boil investing down to figuring out what a company is worth and paying a lot less. Period.” The difficulty comes not in the logistics or specifics of the approach, says Reese, “but with the mind-set it takes to stick with it, because it doesn't work all the time, it must be given time to work and can be extremely volatile.”
The problem isn’t unique. One of the biggest challenges faced by investors is dealing with periods of underperformance. Different investing styles tend to suit different market conditions. There will invariably be times when any strategy just doesn’t work. The discipline is in staying the course and sticking with the rules.
The “magic formula” is too simple for some. They can’t help wanting to improve on it. Says Fred W Frailey of Kiplinger. “Instead of investing in the 25 top-ranked stocks, Marty Ams chooses his 25 at random from among the 50 top-ranked companies — but only if he can find a recommendation for that stock from another source. On Yahoo, certified financial analyst George Peng suggests putting stop-loss orders on Magic Formula stocks to protect against declines.
Fellow Yahooer David Williamson advocates doing your own research on each stock the Magic Formula spits out to “see which ones hold up”.
Ted Wu sells his big winners before a year is up and holds his big losers beyond a year. In early January, easily 90% of the messages on Yahoo's Magic Formula forum dealt with altering the system.”
Again, it’s something Greenblatt predicted. “If you knew enough about each of the stocks that come up,” he says, “you probably wouldn’t buy them — after all, they’re out of favour. A lot of them will lose you money. But a lot of them will make you money and, going in, you don’t know which is which.”
The big question, of course, is whether this is the right time to implement the formula given the potential for a serious downturn. When asked if it might not be better to sit on the sidelines, Greenblatt said the time spent in the market was surer than trying to time the market correctly.
“I still believe that for good business analysts a concentrated portfolio is a good strategy when combined with a long term horizon,” Greenblatt said in 2009. “Actually, what’s happened should give pause to people who think diversification among many stocks in an equity portfolio results in a significant degree of added safety versus owning stakes in a few wellchosen companies.”
So: “What happens when investors are offered a sure-fire strategy? In short, there are those who don’t believe in such things, who won’t even bother to look at it. There are those who just can’t leave well enough alone, who will want to tinker with it. There are those whose need to get rich quick doesn’t allow them the time to let it play out, or who just can’t stick with a thing. And then there are those who will always want to wait for a better time to put it to use.
This leaves only a few to ask: what could possibly be so bad about investing in top-ranked stocks, no questions asked, and getting on with your life until it’s time to pick again?
THERE ARE THOSE WHOSE NEED TO GET RICH QUICK DOESN’T ALLOW THEM THE TIME TO LET IT PLAY OUT