Joel Greeblatt's New Back-Tested Results

A few days ago, I (and everyone else, I assume, whose e-mail address was on file at Greenblatt's Magic Formula website) received an e-mail announcing that Greenblatt's Formula Investing venture had released new back-tested results for the Magic Formula over the last ten years. Here are the results. The first number that jumped out at me was the positive double-digit return in 2007, which seemed surprising given the negative performance of my Magic Formula stocks that year. A glance at the first disclosure offered a partial explanation. From the Formula Investing site:

The results of the model portfolio performance:

• Reflect the strategy of buying an equity portfolio of 24 top-ranked US listed equities that are within the 20% largest companies, as measured by market capitalization. As of June 30, 2009, these companies would have market capitalizations of approximately $890 million or greater.

Well, limiting one's portfolio to names of $890 million or greater would certainly have kept you from micro cap Magic Formula stocks such as these two¹:



Why, one might ask, would someone have bought micro cap Magic Formula stocks in the first place? Greenblatt's book² suggested two reasons:

1) The back-tested results for the all-cap version of the Magic Formula, which included micro-cap stocks, were higher than those of the larger cap version: 30.8% per year, on average, versus 22.9% for the larger cap version.

2) The worst one-year return for the all-cap version was -4% (in 2002) versus -25.3% for the larger cap version (also in 2002).

Recently though, as I noted in a previous post, Greenblatt raised the minimum market cap on the screener on his Magic Formula site from $1 million to $50 million. It's too bad he refused to explain why he did this during his recent Q&A with GuruFocus readers. My guess is that Greenblatt back-tested the numbers for all-cap portfolios since his book was published and found those numbers were uglier than he expected.

¹Another simple modification to the Magic Formula would also have eliminated these two names: including a requirement that each company have positive earnings in each of its previous four quarters. Neither of these companies were consistently profitable; each had one windfall quarter in the last four, and in both cases the windfall was from a one-time legal settlement. I knew this at the time, but (perhaps I over-thought this) I assumed that the inclusion of these sorts of speculative stocks was the reason for the higher back-tested returns of the all-cap portfolios. Perhaps it was.

²See pages 56 and 61, respectively, of The Little Book that Beats the Market.

Answers from Joel Greenblatt

In a previous post ("My Questions for Joel Greenblatt"), I wrote,

GuruFocus announced it will be hosting a question and answer session with Joel Greenblatt and solicited questions from readers. Below are the questions I submitted for Greenblatt. For others' questions, click the link above.

Why did you set the minimum market cap to $50 million on your new Magic Formula screener, when users used to be able to enter a market cap as low as $1 million on your original screener? Did you find that the Magic Formula does not work as well for stocks with market caps below $50 million? If so, would you mind reimbursing me for the money I've lost buying Magic Formula stocks with market caps below $50 million¹?

In your book The Little Book that Beats the Market, you alluded to the dramatic under-performance of a certain investor's² strategies in the few years after he published a book on those strategies. Do you think it's a coincidence that the few years following the publishing of your book have been difficult times for adherents of the Magic Formula as well? Is it possible that, by the time someone decides to write a book on an investment strategy, that strategy is typically due for a period of under-performance?

¹A joke, Prof. Greenblatt. I find that having a sense of humor helps in handling market losses.

²You didn't mention this investor by name, but I believe you were alluding to James O'Shaughnessy.

Yesterday, GuruFocus posted the answers to the questions to which Greenblatt deigned to respond. Greenblatt ignored my first question above, about why he added a minimum market cap to his Magic Formula screener, and offered this semi-answer to my second question,

A new updated study [of the Magic Formula's recent returns] should be published at FormulaInvesting.com soon.

Another GuruFocus poster asked an interesting question, about the merits of using a long-only equity strategy such as the Magic Formula if we are in a secular bear market. Here was Greenblatt's response:

A new updated study should be posted on FormulaInvesting.com in the near future and the results appear to be quite good relative to a flattish market over the last 10 years or so. Also, since the market has not performed well over the last decade or so, that may turn out to be a good time to invest, not a bad time.

It's worth remembering, when reading that answer, that Greenblatt started working on Wall Street "at the end of 1981" (as he noted in response to another question. So he became a professional investor right before the beginning of an unprecedented 18-year secular bull market. It's not surprising, given that experience, that Greenblatt would recommend a long-only equity strategy to the masses, but I wonder whether that makes sense at this point, since, as Vitaliy Katsenelson has pointed out, secular bear markets (or range-bound markets, as he calls them) tend to last about as long as the secular bull markets that preceded them. That means we could be in for another decade or so of more of the same. Perhaps a more opportunistic approach would be better.

Joel Greenblatt Makes Some Changes

Joel Greenblatt made a few changes to his Magic Formula Investing site last month. He notes one of them in his recent column:

[W]e’ve added something new. The site now has description and link to a new website FormulaTrading.com that I helped create with Blake Darcy. Blake is the founder and former CEO of DLJdirect, a pioneer in the internet brokerage field. Formula Trading is designed to make it easy for people to invest using my system. You can invest in one of two ways: either in a self directed manner (you’ll have the tools to easily select, purchase, track and sell stocks chosen by the Magic Formula system) or in a fully managed account (Formula Trading will invest it for you using the Magic Formula system). I am a significant investor in this new venture and have worked with FormulaTrading.com to ensure that it will adhere to the principles of the Magic Formula. (Either way, though, I plan to keep MagicFormulaInvesting.com a free site so that you can follow the Magic Formula system in any manner that works best for you.) This new firm hopes to open in the late spring of 2009.

It's nice to see entrepreneurship is alive and well during these difficult times.

Although he didn't mention it in that column, Greenblatt also made a few changes to the stock screener on his site: it now only lists 30 or 50 stocks for a given minimum market cap (instead of listing up to 100 stocks); it no longer lists the earnings yields and returns on invested capital for each stock; and it no longer allows you to screen for stocks with minimum market caps below $50 million. I sent a message to the site asking whether that last change was made because Greenblatt determined that his system didn't work for stocks below that market cap. If I get a response, I'll post it; if not, I'll try e-mailing Greenblatt directly, which I have had mixed success with in the past.

The photo above, of Greenblatt on his book tour, was borrowed from GuruFocus.

"Freddie Mac is the Cheapest Stock I've Ever Seen"

So said value investor Richard Pzena¹, of Pzena Investment Management, at the 3rd annual Value Investing Congress in New York last November, according to the notes of attendee Amit Chokshi. Chokshi posted the following notes from Pzena's presentation on Seeking Alpha last November 30th (hat tip to commenter "cm1750" on GuruFocus):

* Pzena's talk was entitled 'Evaluating Financials in a State of Panic'
* The only time good businesses sell for cheap prices is during times of distress
* Financial stocks are cheap on a P/B basis against historical multiples
* Freddie Mac (FRE) is the cheapest stock Pzena has 'ever seen':
* Losses are absorbable and GAAP is not useful in evaluating FRE
* Pzena believes the mortgage payment resets that result in higher monthly payments will be handled by borrowers because they will be reluctant to forfeit the equity in their homes
* Fears in the market don’t necessarily impact FRE’s business but are impacting its stock
* FRE Loan to Value = 60% and are mostly in fixed high credit
* Believes FRE will follow similar action to P&C insurance companies

1. Hurricane/natural disaster occurs, P&C insurance companies experience losses, P&C companies raise prices/premiums, P&C stock goes up
2. Housing crisis has occurred, FRE and other industry players will raise fees, tighten credit standards, experience lower losses resulting in strong capital returns and thus improving stock price.

At the time, Freddie Mac (NYSE: FRE) was trading at about $30 per share. Today it closed at 95 cents per share. Off the top of my head, I can't think of a value investor who has made money going long on a financial stock over the last year and a half, but another investor at last November's Value Investing Congress, David Einhorn, has done well shorting Lehman Brothers (NYSE: LEH).



¹Richard Pzena went to Wharton with Joel Greenblatt, author of The Little Book That Beats the Market. In that book, Greenblatt appeared to be alluding to Pzena as "the smartest money manager I know" on p.72.

From Joel Greenblatt to Jim Rogers, Part IV: Conclusion

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. This is the last in the series.

Trying to Find Good Companies When they are Cheap and Poised to Benefit from Macro Trends

Joel Greenblatt's method of screening for good (as defined by ROIC) stocks that are currently cheap (as defined by EBIT/EV) makes intuitive sense. The idea of buying stocks that are poised to continue benefiting (or, even better, start benefiting) from macro trends makes intuitive sense as well (at least it does to me). What I have tried to do so far this year is buy only the Magic Formula stocks that I think have the potential to benefit from macro trends. This has been a challenge, because these sorts of stocks have been relatively scarce on the Magic Formula list.

Why This Sort of Stock has been Hard to Find on the Magic Formula List

Part of the reason for this is that good companies that are benefiting from macro trends often don't stay cheap long. One such example is Graham Corporation (GHM), a small cap company based in Batavia, NY that manufactures vacuum and heat transfer equipment. That may not sound too exciting, but this sentence from Yahoo! Finance's description of Graham's business will give you an idea of the macro trend tail winds behind the company (emphasis mine):

Graham Corporation's products are used in a range of industrial process applications comprising petroleum refineries, chemical and petrochemical plants, fertilizer plants, pharmaceutical plants, plastics plants, liquefied natural gas production facilities, soap manufacturing plants, air conditioning systems, food processing plants, and other process industries, as well as power generation facilities, including fossil fuel, nuclear, cogeneration, and geothermal power plants.

I had my eye on Graham in March, when it was trading in the mid-$30s, and planned to buy it the following month, when I was scheduled to make my Magic Formula trades. Before I was ready to buy it, Graham announced blowout earnings and the stock shot up 20 points, taking it off the Magic Formula list. It's up another 20 points since. Since then, I haven't seen any company on the Magic Formula list positioned to benefit from as many macro trends as Graham Corp.

Another reason it has been relatively hard to find stocks poised to benefit from macro trends on the Magic Formula list is that the list excludes most foreign stocks and ADRs¹. The reason for this is simply that Greenblatt didn't have the data to back-test his system with non-North American stocks; he has said that he still believes that the strategy of buying good stocks cheaply should work in other markets as well.

Combining Joel Greenblatt's Value Methodology with Jim Rogers's Insight that we are in a Secular Bull Market in Commodities

The secular bull market in commodities that Jim Rogers describes (see my earlier post Jim Rogers versus Vitaliy Katsenelson, Part I) is the mother of all macro trends. Since Rogers has written that non-commodity producing companies operating in regions benefiting from the secular bull market in commodities may profit indirectly from it², one way to find more Magic Formula-type stocks benefiting from macro trends may be to apply the Magic Formula screens to stocks in countries benefiting from the secular bull market in commodities. I suspect that a basket of high earnings yield, high return on invested capital stocks in a country such as Australia will outperform a similar basket of American stocks over the next several years. I haven't found (yet) a website that I can use to screen for Magic Formula-type stocks in other countries, but I did recently buy stock in a foreign company after (incorrectly, as it turned out) crunching the Magic Formula metrics on it myself. That company was Alloy Steel International (AYSI.OB), and since I've already threatened to write a post about it, you can expect that post soon.

Although I continue to look for stock ideas on the Magic Formula Investing website, I no longer limit myself to it, and am more concerned with finding stocks that appear to be undervalued based on their future prospects and positioned to benefit from relevant macro trends.

¹In practice, the Magic Formula list has been a little inconsistent with respect to foreign companies. Although it doesn't list any ADRs, it does occasionally list foreign companies that are listed directly on the Nasdaq, e.g., ELOS (Israel), and CAST (China).

²E.g., if an iron mine is operating full tilt and paying a lot of overtime, the miners may have more cash to spend at local restaurants, retailers, etc.

From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Magic Formula

For those unfamiliar with the Magic Formula, it's Joel Greenblatt's Buffett- and Graham-inspired mechanical system of buying a basket of "good" and "cheap" stocks. From Graham, Greenblatt got the emphasis on buying a basket of cheap stocks. In the Magic Formula, Greenblatt uses earnings yield, defined as EBIT/Enterprise Value, to measure "cheapness". Greenblatt uses EBIT instead of earnings to account for differences in interest payments and taxes among different companies, and he uses enterprise value instead of price to account for different levels of net cash or net debt. From Buffett, Greenblatt got the emphasis on finding "good" companies, defined as companies with high returns on tangible capital. Greenblatt calls this return on invested capital (ROIC) and defines it as [EBIT/(Net working capital + Net fixed assets)]. Greenblatt set up a website, Magic Formula Investing.com, to make it easy for individual investors to follow this system. The site ranks its universe of thousands of (mostlyAmerican) stocks by earnings yield and by return on invested capital, and lists those stocks that have the best combined scores (i.e., not necessarily the "cheapest" or the "best", but the stocks that represent the best combination of "cheap" and "good" according to the system).

After reading Joel Greenblatt's The Little Book that Beats the Market in late 2006, I began investing the better part of my money according to the methodology in the book in early 2007. During this time, I read a number of books on value investing (e.g., The Essays of Warren Buffett, Benjamin Graham's The Intelligent Investor, etc.) that reinforced some of the principles of Greenblatt's Magic Formula.

I knew enough about the boom in commodities to be sure to include some of the handful of commodity companies that appeared on the list, but also included companies in other sectors. Aside from the commodity companies, all of which did well, and a couple of small cash-rich drug companies that were bought out for modest premiums, virtually every other stock in the portfolio plummeted. Judging from the lamentations on Yahoo! Finance's Magic Formula Investing Message Group, this has been a common experience.

In fairness to Joel Greenblatt, he did warn in his book that his Magic Formula system (like any mechanical system) wouldn't work all the time, and could under-perform the market for a few years in a row. In the book (pp. 71-73), Greenblatt also alluded to the hot-cold-hot roller coaster performance of O'Shaughnessy's screens in the 1990s, and to a period of under-performance experienced by his friend and fellow money manager Richard Pzena (neither O'Shaughnessy nor Pzena is mentioned by name in the book, but their identities are fairly clear from the descriptions). Nevertheless, the jaw-dropping Magic Formula losses last year (in what was, admittedly, an awful year for most broad-based value strategies) contrasted sharply with the back-tested performance of the Magic Formula system in Greenblatt's book. Over a 17-year testing period, the all-cap portfolio (with a minimum market cap of $1 million) only had one down year (the bear market year of 2002), and that year it merely had a single-digit loss.

After analyzing some of my losers, and see what some successful investors did differently, the lessons I took away were the importance of paying attention to the relevant macro trends, and that in a market when most stocks and most sectors are performing poorly, excessive diversification can be a liability.