Use access key #2 to skip to page content.

MagicDiligence (< 20)

Morningstar's Look at Magic Formula Investing

Recs

7

March 30, 2010 – Comments (3) | RELATED TICKERS: PRSC , WTW

Joel Greenblatt's book The Little Book that Beats the Market, in which the Magic Formula Investing (MFI) strategy was revealed to the world, was first published in December 2005. After an initial rush of publicity, the strategy has largely been relegated to the background since then, despite continuing to vastly outperform the market since it was made public. Only recently are we seeing some of the more mainstream investment media start to discover and write about it, probably due largely to the publicity push behind Greenblatt's Formula Investing venture to provide "do-it-for-me" services for those interested in MFI.

This can be seen recently in a piece published by Morningstar looking into the Magic Formula. Morningstar is most widely known as a company that tracks, rates, and provides data on the thousands of different mutual funds out there, though they also have services that provide equity and ETF ratings. I was rather surprised it took the site over 4 years to write anything substantial about MFI, as their equity review service is highly skewed towards the value investing principles of Warren Buffett, who was tutored by Benjamin Graham, from whom MFI is inspired.

Graham to Greenblatt, For the Win

This Graham-to-Greenblatt connection was something I had not heard about before, but makes perfect sense. Benjamin Graham is often referred to as the "father of value investing", penning such classic investing books as Security Analysis and The Intelligent Investor, the latter of which Warren Buffett has called "the greatest book on investing ever written". According to Morningstar's article, Ben Graham gave an interview in The Rediscovered Benjamin Graham where he cited a formula that had investors choose stocks with a P/E ratio less than 10 and an equity-to-assets ratio over 50%. Stocks would then be turned over when they appreciated 50%, or when they reached a 2 year holding period.

Clearly this formula closely matches MFI. It involves 2 components, one for valuation and the other for business quality, like MFI. In this case, Graham is looking more at financial strength than business efficiency. As Morningstar points out, requiring a 50% equity-to-assets ratio also eliminates banks, which MFI does as well. The requirement would eliminate numerous Magic Formula stocks, particularly the ones with less-than-stellar balance sheets (Providence Service Corp PRSC and Weight Watchers WTW come to mind).

While there is no long-term back-test available for Graham's magic formula, a 1974-1980 back-test found that it nearly tripled the returns of the market over that period!

MFI vs. the Managed Fund Universe

Most interesting is to see how Morningstar compares the historical back-tested returns of MFI to similar returns from their top rated managed mutual funds.

Briefly summarizing, MFI smoked the entire field. The annualized return for MFI from 1988 to the end of 2009 has been a remarkable 19.9%, vs 9.4% for the S&P 500. Morningstar's highest rated fund, Federated Kaufmann (KAUFX), returned an annualized 15.52% over the same period, meaning MFI outperformed the cream of the crop by 4.4% annually! To put that in perspective, 4.4% annually on an initial investment of $25,000 would be worth nearly $62,000 over a 21 year period.

The article continues on to opine as to why actively managed funds so vastly underperformed what is an extremely simple and completely mechanical investing strategy. I think there are some valid points here. The most important is that it makes little sense for a mutual fund running tens of billions of dollars to initiate a position in a company with a $100 million market cap - the impact of gains is just too small.

The takeaway for MFI investors from the article is nearly universally positive. MFI matches tenants of a similar market-beating strategy by a legendary investor. MFI has not just outperformed, but vastly trounced both the S&P and virtually every managed mutual fund over the past 21 years. And, finally, the strategy's focus on small-cap stocks is a key advantage for individual investors that cannot be duplicated by the big money managers.

3 Comments – Post Your Own

#1) On July 07, 2010 at 12:36 AM, dnblack (77.83) wrote:

There is one thing about the MFI that worries me and was not addressed in The Little Book That Beats the Market.

Greenblatt discusses how the strategy can not be implemented by large institutions in large part because it focuses on small cap stocks.  Additionally, he mentions how money managers could potentially lose their job for being so unorthodox in the time it takes MFI to pay off.

These are both well and good.  The thing that worries me is people like you (and me).  If you use the list of magic formula stocks as a starting point for research, presumably you will locate the best stocks in the bunch and identify them as investment candidates.  The majority of people performing this research will come to the same conclusions and choose (roughly) the same stocks.  This would theoritcally create enough buying pressure to inch those stocks off the list (via a reduction in earnings yield).  What remains on the list are the second, third, etc. choices that did not make the first cut.  More people perform analysis on those and find the best ones and push those off the list.

Taking this to its logical conclusion, you are left with a lot of dent and ding stocks that are not good investments (PRSC, CSKI, CHOP, CBPO, SPMD, etc).  Due to the limited size of the stock screen, this formula has now become self-defeating.

I hope this is not what happens in actual practice, but it seems highly likely to me, especially due to the fact that the majority of the highest ranking stocks are so small that they can easily be pushed up by slight buying pressure.

I'm sure this has been discussed before, let me know what you think.

-dnblack

Report this comment
#2) On July 16, 2010 at 2:56 PM, mattp2010 (< 20) wrote:

I am new to investing but have similar concerns.  However, I believe there are several factors that can offset some of the issues you outlined:

-Market Cap: The screener can be set to adjust for companies of various sizes.  Some individuals may just go with the top 30 or 50 stocks to review.  However, other investors may fear owning to many small cap stocks that are thinly traded and often have larger price swings.  This expands the list as these traders look to larger cap stocks.

-Volatility: Many stocks may enter the list for only a short period of time while others leave the list only to return in subsequent months.  The market has had huge swings over the last couple years.  This may create buying opportunities in many different stocks as they enter or are about to leave the list.  I have just recently started using MFI but have found many of the stocks have huge swings even when there is no fundamental change.  This can create buying (or selling) opportunities.

-Personal Preference: I personally don't buy cigarrette companies on the list because I fail to see the value of their product.  I also don't typically buy bio-tech firms on the list because they are to volatile for my tastes and often have products that are difficult to assess.  In addition, a bad clinical trial of a drug could have a very large impact on the stock of smaller bio-techs.

I believe the items noted above help offset some of the concerns you outline.  However, I agree that the more widely used the screener, the less useful it could become.     

Report this comment
#3) On July 16, 2010 at 2:56 PM, mattp2010 (< 20) wrote:

I am new to investing but have similar concerns.  However, I believe there are several factors that can offset some of the issues you outlined:

-Market Cap: The screener can be set to adjust for companies of various sizes.  Some individuals may just go with the top 30 or 50 stocks to review.  However, other investors may fear owning to many small cap stocks that are thinly traded and often have larger price swings.  This expands the list as these traders look to larger cap stocks.

-Volatility: Many stocks may enter the list for only a short period of time while others leave the list only to return in subsequent months.  The market has had huge swings over the last couple years.  This may create buying opportunities in many different stocks as they enter or are about to leave the list.  I have just recently started using MFI but have found many of the stocks have huge swings even when there is no fundamental change.  This can create buying (or selling) opportunities.

-Personal Preference: I personally don't buy cigarrette companies on the list because I fail to see the value of their product.  I also don't typically buy bio-tech firms on the list because they are to volatile for my tastes and often have products that are difficult to assess.  In addition, a bad clinical trial of a drug could have a very large impact on the stock of smaller bio-techs.

I believe the items noted above help offset some of the concerns you outline.  However, I agree that the more widely used the screener, the less useful it could become.     

Report this comment

Featured Broker Partners


Advertisement