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.

"Value Investing Pro"

Alex Garcia, another occasional commenter here, and, like Paul Price, a commenter on GuruFocus as well, has launched a subscription-based investment website as well, Value Investing Pro. From Alex's site:

Welcome To Value Investing Pro

Is it possible to outperform the stock market by using a simple formula. According to Joel Greenblatt’s The Little Book That Beats The Market, the answer is yes. As a matter of fact, this “formula” has produced returns that professional money managers could only dream of. This “magic formula” offers individuals uses a low-risk method to automatically purchase great businesses selling at attractive prices.

Unfortunately, the magic formula has some kinks in the armor which include unprofitable companies that benefit from one time gains, biotechs whose main products patents will soon expire, companies with fad products, etc..

This is where ValueInvestingPro.com comes in. Using basic security analysis, any investor can tweak the formula and outperform the market.

Benefits To You

• Take control of YOUR portfolio


• Discover a 3 step-30 second approach to determine whether a stock requires further  investigation


• Own a tax efficient portfolio


•  Purchase companies, not stocks


•  Receive a weekly list of companies to research


• Discover a time efficient method in which your portfolio is almost completely automated

Good luck with the site, Alex.

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.

Revisiting Return on Invested Capital

As I mentioned in an earlier post ("From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula"), Return on Invested Capital (ROIC) is one of the two metrics that comprise Joel Greenblatt's Magic Formula.

A question raised on the Magic Formula Investing Yahoo! Message Board led to a discussion that highlighted the limitations of this metric. The question was why KSW, Inc. (Nasdaq: KSW), a micro cap HVAC contractor, was no longer on the Magic Formula list. One of the message board's moderators, Marsh Gerda (who also writes an MFI Diary blog) and I separately calculated the Magic Formula metrics to see if we could figure out why the company was no longer on the list.

Greenblatt's Formula for ROIC

Recall from the previous post on this that Greenblatt's formula for ROIC is EBIT¹/(Net Working Capital + Net Fixed Assets).

My ROIC Calculation for KSW

KSW is a $29.4 million market cap company with no debt and $17.75 million in net cash on its balance sheet. Using the standard definition of Net Working Capital (Current Assets - Current Liabilities), I got an ROIC of 38% for KSW. Using that standard definition of Net Working Capital made intuitive sense to me, because it put KSW's excess cash in the denominator of the ROIC formula, so holding so much excess cash reduced the company's return on invested capital.

Marsh Gerda's ROIC Calculation for KSW

Marsh Gerda used Greenblatt's more idiosyncratic definition of Net Working Capital, which excludes a company's excess cash, to calculate KSW's ROIC. He got an ROIC of 1757% for KSW. It appears that he calculated this the right way (with respect to the Magic Formula method) and I calculated it the wrong way, by ignoring Greenblatt's different definition of Net Working Capital.

What The Numbers Mean

Theoretically, an ROIC of 1757% means that, for every additional dollar of capital a company invests in its business, it can earn $17.57 in earnings. In reality, of course, there are a couple of problems with this. First, if a company could really earn 1757% on its cash by investing that in its business, it wouldn't be holding most of its market cap in cash, where, presumably, it is earning less than 4% in annual interest. This would be a problem using my calculation of ROIC as well: 38% may be a lot less than 1757%, but it's still almost an order of magnitude more than the company can earn on its cash.

The second problem is that the amount of capital KSW can profitably reinvest in its business appears to be limited, for a few reasons:

- As an HVAC contractor, it requires little tangible capital, so it can't simply spend a lot of additional capital on new plant and equipment.
- Theoretically, it could use additional capital to expand into other cities (most of KSW's business is in NYC), but the commercial construction business is highly local: a contractor needs relationships with local developers, politicians, etc. (KSW could perhaps get around this by acquiring an HVAC contractor in a different city, but it may not have enough information about that city's construction industry to be an intelligent buyer, and it may not have enough cash to make a suitable acquisition).
- As a construction contractor, KSW probably has to pay up front for supplies and labor before it gets paid on a project. It make sense for the company to hold a certain amount of cash to cover these upfront costs, particularly when credit is less available, and more expensive (especially the sort of construction factoring the company would likely have to rely on).

Similar real-world constraints prevent other companies with theoretically high returns on invested capital from reinvesting most of their cash in their respective businesses. This frequent inability of profitable companies to invest most of their excess cash in their core businesses leads in some cases to the companies returning that cash to shareholders, via dividends or buybacks, and in other cases, to spending that cash on acquisitions (sometimes of businesses that are less profitable than the acquiring company's core business).

¹Earnings before Interest and Taxes

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.