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The Little Firm that Overcharges Investors? aka A Magic Ripoff?

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October 19, 2009 – Comments (8)

As someone who has read and really enjoyed Joel Greenblatt's books in the past I always listen to what he has to say.  His work "You Can Be a Stock Market Genius" is one of my favorite investing books of all-time.  Having said that, to me Greenblatt's latest venture seems like a complete joke.

I received an e-mail from a firm called "Formula Investing" several weeks ago because I had signed up for access to the query tool on Greenblat's Magic Formula website at one point many moons ago.  The concept of the magic formula is interesting and the book that it was unveiled to the world in, "The Little Book That Beats the Market" was pretty good, but do we really need a firm to help us invest using the formula?

This is quote from Formula Investing's CEO, K. Blake Darcy, one of the most hilarious quotes that I have ever read:

"Many readers of The Little Book That Beats the Market wanted to follow the
strategy Joel outlined but were unable to devote the time and attention
necessary to implement the strategy properly"

Ahhh really, K. Blake? People don't have the time or attention to invest using the magic formula? 

The formula was published in a book that Greenblatt wrote so that his children could understand investing, literally.  So the formula that the firm uses to create portfolios is not difficult to understand and it is readily available for anyone in the world to use. 

PLUS, the book states that to use the formula properly one shoud rebalance their portfolio once every year!  Is that really all that time consuming?  Sure one could stagger the year deadline so one stock gets turned over every month or so, but pushing a button or two once a month is hardly time consuming.

I suspect that one could manage a magic formula portfolio for an entire decade in the amount of time that it took the aforementioned person to read The Little Book That Beats the Market.

To me, paying someone use a simple formula that I already know to shuffle my portfolio around once per year for a fee of 1% of my total assets is hardly worth it.  I suppose that assuming that the 1% includes the cost of buying and selling stocks that this isn't that bad a deal if you had a small account with the company, but the fees become outrageous as the size of one's account grows.  Let's say that you had invested the minimum $25,000 with these guys.  1% of that is only $250 and you'd probably incur a trading cost near that with a constantly rotating portfolio of 20 magic formula stocks.  Not too bad.

However, if you were to stick say a cool mil with these guys then you're paying them $10,000 per year for practically nothing and you're getting royally screwed.  Don't get me wrong, I'm sure that there's a TON of "money managers" out there that charge their clients more than this and yet will produce worse results for their clients.  Still, I just don't see the need for these guys.

I like the concept of the magic formula, investing in cheap companies that have high returns on capital is an excellent idea, and I definitely think that it has some value as a stock screen.  However, one thing that bugs me about it is...and correct me if I'm wrong because I heard this in an interview with Greenblatt this morning, that the formula has only been back-tested using a decade's worth of data.  Is that true?  If so, it's hard to believe.  In today's day and age would it really be that difficult to back-test it for four or five times that long?  Perhaps they did and the results didn't look that great.  I would be hesitant to use any investing methodology that assumes what we have experienced over the past decade is a normal stock market or economy.

I personally think that using Formula Investing as a money management firm is a complete waste of money, but I'd love to hear others' thoughts on this money management firm.  Convince me that I'm wrong.

Deej

8 Comments – Post Your Own

#1) On October 19, 2009 at 4:09 PM, TMFDeej (99.40) wrote:

Value Manager Joel Greenblatt Launches Online Money Management Firm Formula Investing at 5th Annual New York Value Investing Congress

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#2) On October 19, 2009 at 4:49 PM, anticitrade (99.66) wrote:

For what it is worth, I think you underestimate the difficulty in conducting an accurate/representative back test on any investing model. 

Principally, because finding 10+ years of financial statements and stock prices is very difficult.  When/if you do find this information, you have to structure your backtest so it accurately reflects when the financial statements actually became available.  Finally, you are left with a survivor bias since you tend to omit all the companies that failed during that time period. 

I spent a lot of hours trying to backtest my model, and decided I was unable to conduct a study that I could have any real confidence in.

However, I agree with you that any investing strategy that is easily understood and carried out by a child is probably limited in actual effectiveness.

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#3) On October 19, 2009 at 4:54 PM, TMFDeej (99.40) wrote:

Anti, we're not talking about a student project here, we're talking about a brand new, well capitalized company that has the resources aka cash necessary to purchase any sort of data that they want. 

Perhaps I just don't understand how the world works, but in this day and age it's absolutely shocking to me that no one has stock market data that goes back further than a decade that Formula Investing could buy if they really wanted to.

Deej

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#4) On October 19, 2009 at 5:06 PM, anticitrade (99.66) wrote:

While I am flattered that you classify my work as a "student project", I must warn you that my model was never actually entered into any science fair of real consequence.

I was also shocked at how difficult it was to find good historical data.  However as you consider the quantity of past tickers, the recycling of ticker symbols, stocks splits, and late filing of statements it gets pretty complex.  Additionally, even I remember when all information was not digitally stored on a computer. 

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#5) On October 19, 2009 at 5:17 PM, joeguice (96.69) wrote:

Caps Score:  99.48

Accuracy: 75.51% Average Pick Score: +29.62

Solely based on stocks that meet the magic formula and are 5 stars in CAPS.  How simple and effective is that?

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#6) On October 19, 2009 at 5:34 PM, anticitrade (99.66) wrote:

joequice-

Those are pretty impressive results. 

I think it would be interesting to have a Fool test out the various automated strategies and provide a review on each.  I would do it myself, but people would understandably question my subjective position.

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#7) On October 19, 2009 at 11:21 PM, Eudemonic (64.47) wrote:

TMFDeej:

 I discovered and read that book in early September and made two picks in September based on the magic formula. I chose five stocks from the Magic List at random. I then ranked their Earnings Yield and ROE.  The two stocks with the best ranking were my CAPS Pick. For September I chose DLX and GNI.  

I don't know how random were my selections nor how scientific and accurate were my ratings.  Nevertheless, I found the Magic Formula worth testing..

As for Greenblatt charging customers a 1% fee. I don't think that is unreasonable. Look at mutual fund managers.. They operate in a black box and speak in tongues when it comes to explaining their portfolio choices and they charge considerably more.

I imagine there could be quite a handful of widowed millionaires who are savvy investors but perhaps have not the inclination to manage their holdings. A manager who charges 1% for a return they see reasonable might be a godsend.  Replacing a light switch is not complicated either, but I know several people who've paid an electrician to do the task for what I thought was an outrageous sum. 

 

 

 

 

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#8) On October 20, 2009 at 10:58 PM, WhoseFoolingWho (< 20) wrote:

Wow Deej... convince you that you’re wrong? It’s tempting to try but that would validate your blatantly false comparison. You’re comparing a professionally managed account to a self managed approach. 

If you want to be fair and offer up valid comparisons, try comparing this managed money offer to the other options available. Look at Euder’s point about the lack of transparency in mutual management schemes not to mention the voodoo involved in the typical fund’s load scheme.  

Viewing the formula investing offer in this light, it seems to be a pretty fair and transparent professionally managed vehicle.

 

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