Today I’m reviewing the idea of Magic Formula Investing (MFI) as introduced in the book The Little Book That Beats the Market by Joel Greenblatt.
The author Joel Greenblatt (Wikipedia bio) is a hedge fund manager. In this book he offered a “magic formula” that beats the market, or so he claimed. The underlying principles for the magic formula are very simple:
- Buy good companies
- Pay a bargain price
At first glance, there is nothing wrong with the two principles. All else being equal, everybody wants good companies, not bad ones. All else being equal, everybody would like to pay a bargain price, not an inflated price. But in real life all else are not equal. Good companies are usually not cheap. Cheap companies usually have something wrong with them. The magic formula attempts to solve this problem. It ranks companies by their return on capital (good companies) and earnings yield (bargain price). It then gives you stocks that rank high when both criteria are taken into consideration.
The book has a support site magicformulainvesting.com. It’ll run the formula for you and produce a list of suggested stocks. For the time being, the site is free. You are supposed to buy 5-7 stocks every 2-3 months until you have 20-30 stocks. Then you will re-run the screen. If the first batch of stocks you bought a year ago are not on the list any more, sell them and replace with new stocks on the list. Repeat for each batch around their 1-year anniversary. It is a very concentrated and high turnover strategy. At any time you only have 20-30 stocks and you are replacing 100% of your portfolio every year if the stocks you own fall off the list. Instead, if you buy a total market index mutual fund, you will own thousands of stocks, not just 20 to 30, with very little turnover.
Does it work? Greenblatt said it did over 17 years from 1988 to 2004.
“Over the last 17 years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year.” (p. 52, italics original)
There’s no way to independently verify that record but let’s accept it as accurate. What about the next 17 years? That’s what I’m interested in. I don’t have a time machine which turns the clock back 17 years. And you know what they say about past performance and future performance. As rich as he may be, Greenblatt doesn’t offer any warranty on how the magic formula will turn out in the future. If you have poor results, don’t come crying. He will not make you whole. You are supposed to believe in the formula and stick with it.
“Remember, you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work!” (p. 135, italics original)
What if it didn’t work out even after 5 years? I guess Greenblatt will say you should stick with the formula even longer. Or maybe you will get a “oops, sorry.”
Is this strategy something you can use for your entire portfolio? I don’t think so. Betting everything on 20-30 stocks is very risky. I went to magicformulainvesting.com and got my list of stocks with the minimum market capitalization set at $100 million, as the book recommended. I then run Morningstar’s Instant X-Ray tool on them and here’s what I got:
So basically it wants me to invest 64% of my money in small cap stocks, whereas small cap stocks make up only less than 10% of the U.S. stock market. No way. Can you spell RISKY? Will it beat the market? Maybe, maybe not. I’m not going to wager all my investment dollars on it to find out.
JLP at AllFinancialMatters.com started a simulation on Magic Formula Investing in January 2007. He got good results for the short 6-month period until the last update in early July. But note he is only doing it with hypothetical dollars, not real money. It will also be interesting to see how Magic Formula Investing did in the recent stock market sell-off. If blogger Marsh_Gerda’s experience is typical, it’s not pretty. He had accumulated healthy extra returns over the broad market since February 2006. In three weeks, those extra gains built up in the last 17 months were completely wiped out.
What about doing this only for “play money”? Well, I don’t have “play money.” All my investments are from my hard earned dollars. Why do I want to “play” or gamble with them? Besides, what’s the point of beating the market on only 2% of your investments? How much difference will it make?
“In the financial marketplace, you get what you pay for, if you are careful. If you try to get more, you get burned.”
That’s something you always have to remember whenever you are attracted to any scheme, no matter what it is. In the end, I guess I’m not that interested in beating the market. If I beat the market, something is wrong. That means I took a bet and the bet came in my favor. But wait a minute, why did I take a bet with my hard earned money in the first place? Gambling is not investing.
Rating: * (avoid).