How to in­vest like ... Joel Green­blatt, the pro­fes­sor with a magic for­mula

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Few fund man­agers are ca­pa­ble of ex­plain­ing in­vest­ing in sim­ple terms. Most pre­fer to keep what they do a mys­tery – some­thing that’s best left to a hand­somely paid pro­fes­sional. Wall Street hedge fund leg­end Joel Green­blatt is an ex­cep­tion. He founded Gotham Cap­i­tal – now Gotham As­set Man­age­ment – in 1985, and has been a pro­fes­sor at Columbia Busi­ness School since 1996, spe­cial­is­ing in “value” in­vest­ing.

Ac­cord­ing to Fred­erik Van­haver­beke’s 2014 book Ex­cess Re­turns, Mr Green­blatt man­aged to achieve a com­pound an­nual re­turn of 45pc over 19 years.

By com­par­i­son, the famed Fi­delity in­vestor Peter Lynch man­aged an an­nual rate of 29pc over 13 years, and War­ren Buf­fett has man­aged a 20pc plus av­er­age, al­though that has been sus­tained for more than 50 years. Mr Green­blatt has also writ­ten a num­ber of books, most no­tably the best­selling The Lit­tle Book that Beats the Mar­ket.

In it, he out­lines his so-called “magic for­mula”. It’s a fancy name that at its core has a sim­ple goal: buy good com­pa­nies at bar­gain prices. The be­gin­ning of the book is also an en­ter­tain­ing, sim­ple guide to un­der­stand stock mar­ket in­vest­ing.

He ex­plains that while mar­kets tend to value com­pa­nies fairly in the long run, over the short term they can be wildly ir­ra­tional, and value stocks at both de­pressed and in­flated prices. That pre­sents op­por­tu­nity.

For­mu­las that claim to have found a se­cret recipe for in­vest­ing are of­ten prob­lem­atic. Many the­o­ries claim to show as­ton­ish­ing per­for­mance when tested with his­toric data, only for their ap­par­ent These are the top ranked UK stocks based on the magic for­mula, ac­cord­ing to Stock­o­pe­dia. This list should not be used to pick a small num­ber of stocks.

STM Sportech LSL Prop­erty In­de­pen­dent News & Me­dia iEn­er­gizer Sys­tem1 Ocelot Part­ners Char­ac­ter Nexus In­fra­struc­ture Win­can­ton PayPoint Hogg Robin­son SCS In­di­v­ior As­setco RM Har­vey Nash Air Part­ner Trin­ity Ex­plo­ration & Pro­duc­tion Safestyle UK Fer­rexpo Mis­sion Mar­ket­ing Mor­tice Ep­win Christie Somero En­ter­prises Con­nect SDX En­ergy in­fal­li­bil­ity to be thwarted by a shift in the in­vest­ment land­scape. Oth­ers are sim­ply too com­pli­cated to be eas­ily used by an or­di­nary “DIY” in­vestor, or re­quire in­ac­ces­si­ble data.

In­vestors can also lack the pa­tience and dis­ci­pline to stick with this type of num­bers-based in­vest­ing through rough pe­ri­ods, and di­verg­ing from a sys­tem is usu­ally where things go wrong.

How­ever, writes Mr Green­blatt, “If a for­mula worked all of the time, every­one would use it, and it wouldn’t work” as there would be no bar­gain stocks. He ar­gues that the in­abil­ity of many in­vestors to stick with a for­mula al­lows it to work for those who do.

The be­gin­nings of value in­vest­ing, and Mr Green­blatt’s for­mula, start with famed in­vestor Ben­jamin Gra­ham.

His own for­mula aimed to se­lect com­pa­nies that were val­ued so low that the pro­ceeds of a fire sale of their as­sets would be greater than the val­u­a­tion. Mr Gra­ham man­aged a 21pc an­nual re­turn over 20 years, ac­cord­ing to Ex­cess Re­turns.

“Un­for­tu­nately, the for­mula was de­signed dur­ing a pe­riod where many stocks were priced cheaply,” wrote Mr Green­blatt. His for­mula is a de­vel­op­ment of the same idea.

Tak­ing the US stock mar­ket, the magic for­mula in­volves rank­ing com­pa­nies on “earn­ings yield” and the re­turn on cap­i­tal that they are able to gen­er­ate. The idea is to iden­tify strong com­pa­nies and then choose only the cheap ones.

Re­turn on cap­i­tal is a mea­sure of the re­turns a busi­ness can gen­er­ate by in­vest­ing, in new equip­ment or store lo­ca­tions for in­stance.

Mr Green­blatt’s view is that a busi­ness’s abil­ity to gen­er­ate a high re­turn on cap­i­tal, even for one year, means that there is some­thing special about that com­pany, “oth­er­wise, com­pe­ti­tion would al­ready have driven down re­turns on cap­i­tal to lower lev­els”.

That takes care of the “good com­pany” part of the for­mula. Earn­ings yield, which is a val­u­a­tion met­ric, then makes an as­sess­ment of whether or not firms are cheap.

For most peo­ple, he rec­om­mends screen­ing for com­pa­nies that are $50m (£38m) to $100m (£76m) in size or larger. The com­pa­nies are then ranked in each cat­e­gory, with one be­ing the best. The rank­ing on each mea­sure is then com­bined, and the low­est com­bined score gets the top spot.

The aim is then to buy the 20 to 30 high­est-rated stocks, based on the com­bi­na­tion of those two mea­sures, and hold each one for a year.

To get started, Mr Green­blatt sug­gests buy­ing five to seven stocks ev­ery few months, un­til a port­fo­lio is built up, then chang­ing them out as each hold­ing reaches a year old.

He has set up a web­site, mag­ic­for­mu­lain­vest­, which al­lows in­vestors to screen for stocks based on his spe­cific meth­ods. How­ever, both the for­mula and screen­ing tool have been de­vel­oped for the US stock mar­ket.

Those aim­ing to ap­ply this method­ol­ogy to the UK or an­other mar­ket have to im­pro­vise. He sug­gests that those us­ing other screen­ing ser­vices should use a com­bi­na­tion of re­turn on as­sets (in place of re­turn on cap­i­tal) and price-to-earn­ings (p/e) ra­tios, in place of earn­ings yield.

He also adds a few more rules. These in­clude elim­i­nat­ing all util­i­ties and fi­nan­cial stocks, leav­ing out firms with ul­tra low p/e ra­tios of five or less (which in­di­cate un­usual data), and tak­ing out com­pa­nies that have re­leased their earn­ings in the past week.

He also ad­vises in­vestors to elim­i­nate all for­eign com­pa­nies, but that too is aimed at in­vestors in the United States. This is not, he says, a method to be used to pick in­di­vid­ual stocks.

In his hedge funds he uses the ba­sis of this for­mula, but then in­cludes more com­plex ele­ments, such as pre­dicted fu­ture earn­ings for the next three or four years.

His view is that those who don’t have the ca­pac­ity to carry out such anal­y­sis “have no busi­ness in­vest­ing in in­di­vid­ual stocks”.

“Even pro­fes­sion­als have a hard time mak­ing ac­cu­rate earn­ings pre­dic­tions for in­di­vid­ual com­pa­nies,” he said.

In­stead, the magic for­mula ef­fec­tively picks 20 to 30 stocks at a time in ag­gre­gate, and cap­tures the av­er­age re­turn of those stocks.

This will go against the nat­u­ral in­cli­na­tions of many in­vestors. The screen is likely to gen­er­ate some stocks that, if as­sessed in­di­vid­u­ally, in­vestors would nor­mally avoid.

The hedge fund leg­end has re­turned 45pc a year for two decades. And he’s happy to share the se­crets of his suc­cess, says James Con­ning­ton

The test­ing car­ried out on the for­mula by Mr Green­blatt has also all been in the US. No one else has been able to re­pro­duce his re­sults.

From 1988 to 2009, the strat­egy re­turned an av­er­age an­nual re­turn of 24pc, com­pared to 10pc for the S&P 500 in­dex, ac­cord­ing to Mr Green­blatt’s up­date to his book in 2010. That would have turned a $10,000 in­vest­ment into more than a mil­lion dol­lars.

He freely con­cedes that the for­mula doesn’t work all the time, and there can be months or years when it fails to per­form.

Whether or not an in­di­vid­ual in­vestor could have repli­cated this ex­actly is dif­fi­cult to say. It’s un­clear, for in­stance, if deal­ing costs have been in­cluded, which would sig­nif­i­cantly eat into re­turns for a smaller in­vestor, given that the strat­egy re­quires switch­ing out of all 30 shares each year.

Stock screen­ing ser­vice Stock­o­pe­dia has cre­ated a repli­ca­tion of the magic for­mula screen, which it has ap­plied to Europe and the UK too.

Over the past year, the UK ver­sion has re­turned 30pc, and over six years it has re­turned 69pc, for an an­nu­alised re­turn of 9.4pc. That is still dou­ble the FTSE 100’s re­turn over six years but not as dra­matic as the US re­sults sug­gest.

Re­cent per­for­mance has been stronger in Europe – in­clud­ing the UK. Over one year, it has re­turned 31pc, over two years it has re­turned 79pc, and in just over four years it has re­turned 98pc, for an an­nu­alised re­turn of 17pc.

A clear down­side to this strat­egy is that if the whole of a mar­ket is ex­pen­sive – as many are con­cerned is now the case – there are very few bar­gains left to buy.

Mr Green­blatt’s an­swer to this po­ten­tial flaw is that if stocks are split into 10 groups based on their magic-for­mula rank­ing, the top group in his test has been shown to out­per­form the sec­ond, the sec­ond the third and so on.

So even if the whole mar­ket is ex­pen­sive, the top-ranked magic for­mula stocks still do bet­ter.

Re­mem­ber too, that the for­mula was de­vised be­fore the era of ul­tra-low in­ter­est rates flooded mar­kets with cheap cash.

‘At the heart of his for­mula is a sim­ple goal: to buy good firms at bar­gain prices’

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