Value investing pioneer Benjamin Graham argued in favor of the cyclically adjusted price-to-earnings ratio as a good way of judging a firm’s actual earning power, and current value investing guru Joel Greenblatt recommends following the Magic Formula, which sounds pretty silly but has beaten the market for the last two decades. So it’s only natural that CAPE Ratio would ask the question – what happens if you try to use both?
For those who don’t know, CAPE looks at stock price divided by a company’s average earnings over ten years, adjusted for inflation. The idea is to smooth out short term volatility and get a better sense of the company’s long-term potential. Greenblatt’s Magic Formula throws out a number of potentially problematic stocks from the get-go (all foreign companies, financials, utilities) and then ranks everything else by return on capital and earnings yield.
CAPE Ratio compiled by using the Magic Formula
CAPE Ratio started by compiling a list of 20 attractive companies using the Magic Formula, and then re-ranked them according to CAPE. The top five stocks they came up with were Great Northern Iron Ore Properties (NYSE:GNI), Strayer Education Inc (NASDAQ:STRA), ITT Educational Services, Inc. (NYSE:ESI), Apollo Group Inc (NASDAQ:APOL) and Mantech International Corp (NASDAQ:MANT).
Trying to reconcile the two different approaches to value investing is interesting, but even CAPE Ratio admits that this may not be the best way to do it. “The method we have provided is probably not a bad way of conducting an analysis of the Magic Formula generated list, however it is still most likely an inferior approach to Cyclically Adjusting the entire Greenblatt formula,” the company wrote in a recent newsletter.
But even if you went the extra mile and used CAPE to adjust Greenblatt’s formula directly, there’s also an inherent danger in relying too much on screeners.
Charles Sizemore on investment in Dell
Over the summer, Charles Sizemore at Forbes gave a great example of what could go wrong from blindly following formulae. “Some companies are not really investable at this point, or at least shouldn’t be,” writes Sizemore. “Given that Dell Inc. (NASDAQ:DELL) is currently in the midst of heated dispute over whether to take the company private, this is probably a company you should avoid.”
CAPE and the Magic Formula have both proven themselves as great ways to look for new investment ideas, but there’s still no replacement for due diligence.
