Joel Greenblatt's Magic formula
“Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot”- Joel Greenblatt
“On Wall Street, there ain’t no tooth fairy!”- Joel Greenblatt
In the last blog, I wrote about Index and Mutual funds, but what if you don’t want to invest passively without research and want to invest in individual companies to earn higher returns than the market averages then this is an interesting read.
With “The Little Book That Beats the Market" and the follow-up "The Little Book That Still Beats the Market," Greenblatt's goal was to write books simple enough that his children could understand and use yet have them reflect the core values used by Greenblatt to manage his portfolio. The result is an easy-to-follow process that relies on two simple rules: Seek out companies with a high return on invested capital (ROIC), and that can be purchased at a low price that provides a high pre-tax earnings yield. These two concepts - buying a good business at a bargain price - make up the "magic formula."
Stock prices vary a lot in the short term, allowing you to find bargains. The business's value may change over a year, but it does not change as much as the stock prices change. For example, let's see HDFC its current price is 2295 but it has a 52-week high price of 3021 and a low of 2026. Let’s say according to your estimate the value of the business is around 2500 per share (random estimate) now if you saw this as the value of the business you would find 2026 a bargain and 3021 as overpriced. So, there are a lot of opportunities to find bargains as there is so much movement in the price offered to you by Mr Market, so all you need to do is value a business relative to the price Mr market offers you to make your decision.
Earnings yield: Let’s say there is a business of candles known as Zoe’s candles. Let’s say it is offering the public 1 million equal shares in the company to raise capital. Their earnings last year were 2 million rupees, so that is 2 rupees (2 million divided by 1 million ) in earnings per share. Now Zoe decides that the price per share should be 20 rupees, which would make the market capitalization 20 million. So, the earnings yield comes up to 10 per cent per share (2 divided by 20 into 100). Now if the earnings are different let’s say the earnings are 4 million rupees this would cause the earnings to yield to be 20% per share (4 divided by 20 into 100). Now let’s say the earnings are less than 2 million and the earnings are 1.2 million now the earnings yield is a mere 6% (1.2 divided by 20 into 100). The aim for an investor is always to get the best earnings yield so the higher the earnings yield the better. The earnings yield essentially shows you the difference between the price and the earnings. The earnings yield tells the shareholder his entitlement of earnings. It shows a shareholder the earnings per share that he/she has held.
Return on capital employed (ROCE): Zoe’s candles want to open a new shop, so they invest in a new factory. It cost her Rs 10 lakhs to open a new factory which produces candles, and it costs her 10,000 rupees a month to rent a new store in a mall. So, for a new store, the business has spent Rs11,20,00. The store generates earnings of over Rs 5 lakhs in the first year itself giving the store a return which is almost half the investment in the first year itself. This means Zoe has a ROCE of 44.64% which is very good. Zoe’s competitor Serenity by Jan opens a shop in front of her store to try to compete, so she spends the same amount on production and the rent but the return on this investment was Rs 3lakhs in the first year. Jan spent the same amount of capital as Zoe but got a ROCE of 26.79% which is not bad but when you compare it with Zoe’s candles it is almost a 20% difference. This example shows that a company with a higher ROCE will produce better earnings and profitability. A high ROCE also signifies the growth of a company as it shows the amount of return on the investments made by the company.
Companies with high ROCE should attract more competition as the others see their business getting a high return and decide to join the business and this could harm the company's ROCE as they would sell less compared to what it was when there was no competition so essentially this could mean a company with high ROCE could go on a downward spiral. So how does the magic formula work then? But the fact that a company has a high ROCE even temporarily means that they are doing something right and they could have a competitive advantage ( moat) or it could have innovated a new business concept or product which is superior. In short, companies that have a high return on capital have some sort of competitive advantage of some kind which keeps competitors from destroying the ability to earn above-average profits. Some companies might have their returns go down due to competition but on average the magic formula companies are finding good companies. And what does the magic formula do with these good companies, it buys them at a bargain price. In simple words, it buys above-average companies at below-average prices.
The entire formula is based on these two ratios. They show a business with high growth at a bargain price. It seems easy and it is.
The hard part about this is not the process. The hard part is making sure that you understand why the magic formula makes sense. The hard part is continuing to believe that the magic formula still makes sense even when friends, experts, the news media, and Mr Market indicate otherwise. Lastly, the hard part is just getting started.
The returns that have come from magic formula investing are as follows
Particulars | 30 stock portfolio | BSE Sensex |
Average return | 17.73 | 9.89 |
CAGR | 13.89 | 9.31 |
Median | 18.49 | 10.11 |
Maximum | 85.17 | 31.61 |
Minimum | -22.82 | -8.10 |
Source:
Preet, Simmar and Gulati, Ankita and Gupta, Arnav and Aggarwal, Aadit, Back Testing Magic Formula on Indian Stock Markets: An Analysis of Magic Formula Strategy (October 19, 2021). Paideuma Journal of Research, Vol XIV Issue 10 2021, Available at SSRN: https://ssrn.com/abstract=3945468
In the USA Joel Greenblatt tested the formula himself and these were the returns generated by the magic formula in the USA
.
Source: The Little Book That Still Beats the Market 2006
From the two pictures, it is clear that this formula has worked and has outperformed the index.
Looking at the negatives of the magic formula now.
Based on research conducted by Yuval Taylor in the Portfolio blog 123 titled Does Joel Greenblatt’s “Magic Formula” Investing Still Work? Dated Sept 14, 2020, you can read it here.
Some snapshots of this blog criticizing it are as follows:
“After a spectacular 2009 (in which the Greenblatt portfolios beat the market by an average of 50%), stocks bought in 2010 lagged the market by 3%, and stocks bought in 2011 lagged the market by 28%. They beat the market by 7% in 2012 and 11% in 2013, but lagged the market by 9% in 2014, 10% in 2015, 13% in both 2016 and 2017, and 21% in 2018. Lastly, stocks bought in 2019, in the first nine months of that year and held for one year, lagged the market by 23%. Ouch! If you’d bought the thirty highest-ranked stocks every week over the last ten years and held them for one year, you would have made an average of 2.20% per year, while if you’d bought the S&P 500 ETF SPY instead, you would have made an average of 13.02%.”
So contrary to what the research showed in 2009 the magic formula has not been working.
Why is the magic formula not working anymore though the principles of the formula were accurate and many value investors would use this main idea of buying a good company at a bargain price?
“If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), . . . you can achieve investment returns that beat the pants off even the best investment professionals (including the smartest professional I know). You can beat the returns of top-notch professors and outperform every academic study ever done. In fact, you can more than double the annual returns of the stock market averages!”~Joel Greenblatt
One clear problem that I can point out from this formula is that it is oversimplified and I cannot imagine someone like a Buffet or a Munger simplifying investing into a formula so I guess one of the reasons why it has failed is that it has failed to grasp that finding bargain prices requires more than Earnings yield and also to check growth and quality of a company only one ratio will not help you.
“On Wall Street, there ain’t no tooth fairy!”- Joel Greenblatt
This is an irony because in this book Joel Greenblatt makes the magic formula sound a little too easy and it makes the readers think that Wall Street is a tooth fairy. To succeed in the stock market there is a lot of effort that takes place, and it is not at all easy to beat the market with a “magic formula”
So, after looking at the positives and negatives of the magic formula here is my conclusion.
1. The book written by Joel Greenblatt was meant for children to teach the important fundamentals of value investing so for every investor who wants to start it is very important to grasp the basics
2. Since it was originally meant for children, it seems a little oversimplified.
3. The magic formula has worked for most of history as shown by Greenblatt, but it has also been shown by his criticizers that it has stopped working
4. The formula may or may not work but the ratios in this formula are very important
5. The basic idea in this book and about the magic formula is simple and should be aimed at all “Buy good companies at bargain prices.” This is the art of value investing.
Comments
Post a Comment