Have you heard of Magic Formula Investing? Okay, I don’t blame you if you stopped reading already. I too was very skeptical. It just sounds too hokey. I dismissed it out of hand for a long time.
But the author of the book kept getting mentioned by some of the brightest investors I know. They all look up to Joel Greenblatt as an unparalleled genius. He has apparently had a phenomenal track record over decades and is in a league almost completely by himself when it comes to returns. How can I ignore this guy and the wisdom he shares, just because the book title sounds cheesy? I don’t know but I did just that for all too long. Greenblatt is super rich and isn’t writing books to pay his bills. I believe he truly wants to help the little guy by making successful value investing easy and effective.
Greenblatt is a value investor. What does that mean? Well for him it means you should buy companies only when they are cheap. What if the company is so cheap because it is dying away? Are you buying a value trap? The way to adjust for that risk is to select stocks that have excellent earnings. He looks at just these two measures Earnings Yield (the opposite of the P/E) and ROIC (Return On Invested Capital). He has proven outstanding results by simply using these two metrics.
He has some conditions such as holding them for at least a year and owning 20-30 stocks or more at a time for diversification, but basically the whole system comes down to those two simple factors. He even maintains a website that you can use for free to implement his strategy. Pick how many stocks you want. Pick how big you want the companies. Bingo it creates your list.
Buy from this brilliant hedge fund manager’s list and you may very well make 2-3x the market’s returns. Why doesn’t everyone do this if it works so well?
- It seems too ridiculously simple to be effective. We brainy analysts want to complicate it and put our own spin on the selection process. There is still room to do that. Use a different criterion that is important to you, but do it within his list. Then it is like shooting fish in a barrel. Every fish you hit will be a great one even if your process doesn’t add value.
- Tracking error. Since this is very different from the overall market there can be long stretches where it underperforms the market. Most of us will then start second guessing the system. We bail out – and at the exact wrong time.
If you are looking for an easy way to implement value investing to pick stocks, consider this method. It is more sophisticated than the book’s title suggests. You may want to allocate only 5-10% of your portfolio for this until you know for sure you can (emotionally) handle all the tracking error. Also, it is best done within your retirement accounts to avoid the tax consequences of frequent trading. Lock up the other 90% into broad market index funds and see which beats out. My bet is with Greenblatt.