Joel Greenblatt Interview with GuruFocus.com
Last week, Joel Greenblatt, the founder and "godfather" of Magic Formula Investing (MFI), gave an interview to value investing supersite GuruFocus.com. In the interview, he answered a number of questions relating to Magic Formula Investing, his new FormulaTrading venture (which MagicDiligence reviewed here), and on the market and his investing principles in general. I encourage all MagicDiligence readers to take a look at the interview, as it is an enlightening read. Some common themes ran through his answers, and I wanted to comment on a couple of them in this article. Joel's comments to GF are italicized, with my comments below. All comments belong to GuruFocus, and are reprinted with permission.
Theme #1: Investing Should be Simple
I think the exercise of trying to figure out how to simplify concepts has been incredibly helpful to me over the last 13 years of teaching and I hope my students have benefited from it.
I do plan to write another book. It will also be about a basic framework for successful investing written in a way I hope my kids can understand.
One of the most prevalent themes with Greenblatt's approach to investing is simplicity. This is in stark contrast to what most money managers want you to believe. One recent commercial by a large money management firm equated managing your own investments to performing surgery on yourself! That is plainly ridiculous. Of course, they want you to believe this so they can earn their thousands of dollars in management and commission fees, all the while delivering below-market returns on your money. Greenblatt believes (as does Warren Buffett) that investing is actually a simple task that is, at its core, easy to understand by anyone. The Little Book that Beats the Market is easily understood by even the most novice investor, and Greenblatt apparently plans to write another book that follows this model.
...I usually just look at a simple multiple to normalized earnings. If I can buy something at a very low multiple and I have confidence in the earnings stream, I don’t have to calculate a DCF to know whether I want to buy it.
One common thing that MagicDiligence sees in the MFI community is a constant effort to "improve" the strategy by adding complexity. The above quote is exhibit A that it doesn't take a master's degree in statistical analysis to achieve success in the market, but it does take some common sense and foresight to determine what companies have a sustainable earnings stream and what companies do not.
Theme #2: Have a Long-term Horizon
I still believe that for good business analysts a concentrated portfolio is a good strategy combined with a long term horizon.
Once again, the secret to success in following the formula strategy is patience, a quality in short supply for both professionals and individual investors alike.
I think investors should have a large portion of their assets in equities over time. I don’t know too many people that are good at timing the market relative to macro-economic events.
MFI officially came on the scene in late 2005, and yet there has been volumes written already about how the strategy does not work, or how it is not right for "this market", or how it is "too aggressive" and/or "too conservative" in "current market conditions". That's a lot of analysis based on less than 4 years of practice! The fact is, patience is a key virtue that few active investors possess. In any investing career, you will have periods where you make bad stock picks, and periods where you make good ones. The key is to maximize the good ones and minimize the bad ones, which is what MFI is designed to do. By sticking with it, through thick and thin, you maximize your opportunity to pick stocks that will outperform the market. In the long run, your chances of success are much better than trying to time when a completely unpredictable (no matter what analysts say) global market will go up or down.
Theme #3: Comments Applicable to MagicDiligence's Mission
Before I list some comments, I want to make abundantly clear that Joel Greenblatt is in no way affiliated with this site, nor has he endorsed it, nor do the comments below apply specifically to MagicDiligence. With that said...
The Magic Formula works on average. It can either be used as a screening device to find companies to do more work on to determine whether earnings are sustainable and predictable or as a way to accumulate a basket of 20 or 30 companies that on average are cheap and good. If you don’t plan on doing additional research, buying individual companies without further research would obviously be imprudent.
(Responding to question on future opportunities for capital investment): The big picture is: the main thing you should be concerned about in the future are incremental returns on capital going forward. As it turns out, past history of a good return on capital is a good proxy for this but obviously not foolproof. I think this is an area where thoughtful analysis can add value to any simple ranking/screening strategy such as the magic formula.
When doing in depth analysis of companies, I care very much about long term earnings power, not necessarily so much about the volatility of that earnings power but about my certainty of “normal” earnings power over time. My goal is to buy a company at a low multiple to normal earnings power several years out and that the company earns good returns on capital at that level of normal earnings.
A holding period of more than one year also works quite well as the factors are persistent in years 2 and 3.
These three quotes describe some of the mission here. By researching MFI stocks, we are looking for companies with sustainable competitive advantages that allow them to re-invest earned capital at attractive rates. Also, at MD we don't mind holding an MFI pick for several years as long as it remains on the screen. If a stock is staying on the Magic Formula screen, that means its returns on capitals are still good (sustainable), but the market is taking a little longer than normal to recognize the value. There is no reason not to hold, as Joel points out in one of the comments.
If index funds beat most active managers and the Magic Formula can beat the index funds by a wide margin, this may be a very good option for individual investors.
A few members have questioned the benchmarking of the MagicDiligence Top Buys portfolio against the S&P, but this quote sort of explains the reasoning. Benchmarking against the overall MFI screens is not really practical, since there are a virtually infinite number of potential MFI screens and it is impossible for an investor to exactly duplicate their results. Index funds can and do duplicate the S&P 500, hence the returns can be matched by an individual investor as an alternative to MFI.
And, lastly, some interesting tidbits from the interview...
(Greenblatt on some of his favorite books): A few of my favorites are: “The Essays of Warren Buffett” edited by Lawrence Cunningham, “Moneyball” by Michael Lewis and “The Invisible Heart” by Russell Roberts.
MagicDiligence has coincidentally published a review of Moneyball, and is working on one of The Essays of Warren Buffett, which is an excellent book indeed.
During the 10 years that Gotham Capital managed outside money from 1985-1994 the portfolio was rarely leveraged although small portions of the portfolio were sometimes invested in options.
So many hedge funds abuse "leverage", or debt, but Greenblatt's fund does things the right way - earn capital on capital and grow organically. This is the way MagicDiligence likes to see companies grow, as well.