“Value investing is simply figuring out what something is worth and paying a lot less for it” – Joel Greenblatt
I often describe my investment philosophy as a synthesis of ideas from Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. At the core of my strategy is Graham and Schloss’ quantitative methods for valuing stocks. It’s far more difficult to make mistakes when you simply make obvious, simple decisions based on valuation. In each investment, I want to ensure I’m not taking on valuation risk. Many investors (including most value investors) overly complicate things and this can often lead to counterproductive results. That’s why many smart guys get mediocre results. They try too hard.
One of the things I occasionally like to do is look at simple, diversified value portfolios I track to see how they are performing. I think of these like “value indices”. Rather than track the S&P, which I hope to surpass by large margins over time, I also want to track the results of simple value indices which are very easy to replicate in practice if one wanted a passive approach that would likely beat the S&P over time. I’m talking about tracking things like the 50 S&P stocks with the lowest P/B or P/E ratios, and other simple value portfolios.
Please remember that these are hypothetical portfolios and past performance doesn’t guarantee future results.
Understand Quant, But Don’t Let the Computer Do 100% of the Thinking
Again, just to be clear: I don’t invest in these quant strategies, I simply track a group of 8 or 10 of these portfolios… more just for fun than anything else. Most of these hypothetical portfolios are up a 20-35% this year, which is remarkable, but not surprising given that the market has performed very well YTD.
I don’t invest using these strategies for two reasons:
- One, I hope to do significantly better over time (3-5 year periods-any 1 year period could go either way).
- Two, although I admire a few investors who follow value quant strategies, I have never been a fan of completely systematic strategies with my own capital.
Some quant guys have very convincingly shown that quant strategies outperform even the smartest discretionary value investors. Their argument against making discretionary decisions is that it’s too easy to have lapses in judgement and make poor decisions. This is likely true, but it’s the reason value investing works. Discipline and common sense are required to have a sustaining career as a value investor. And it’s those traits that many lack. For those who are not disciplined, it’s likely better to use a computer to tell them what stocks to choose. For these folks, I truly believe that value quant strategies will likely work very well over time relative to their own results.
But the one thing that isn’t covered as much in a general sense is risk management… i.e. protecting the downside.
The Best Risk Managers Are Humans
The above subtitle might be the exception rather than the norm. For many investors, a quant value strategy (or an index fund) might be less risky than managing your own portfolio. But the best investors in history have generated far better results with far less risk of permanent loss (not volatility) than the best computer systems.
My first priority in investing is protecting capital from permanent loss. In order to properly do that (in my opinion), I need to be able to know something about what I own. I don’t want to invest my hard earned capital (nor my clients’ hard earned capital) into stocks that I’m not familiar with simply because they show up on some valuation screen that has historically said that these stocks do well.
I’m not suggesting quant strategies don’t work… it’s clear that a variety of quantitative value strategies have done well over time (Graham’s quant ideas, Greenblatt’s ideas, net-nets, etc…), and will probably continue to do well in the future, but I’m just more comfortable understanding something about the investments I make. This is not to say that I understand everything about each business, but I want to be able to understand why the investment makes sense. Simply allocating across 30-50 value stocks without any reason (other than the computer said to) is a difficult thing to do, and even more difficult once the strategy begins to underperform for a period of time-an inevitable occurance in just about all value strategies-they almost always work over time, but not always each month, quarter, year, etc….
Magic Formula is My Favorite “Quant” Strategy
I’ve talked about Joel Greenblatt’s Magic Formula before… it’s a value investing strategy that uses two simple inputs (return on capital and earnings yield) to pick a group of “cheap and good” stocks. Basically, Greenblatt wanted to test the ideas he used at Gotham Capital, where he was able to make 40% annual returns for 20 years using a combination of simple value investing ideas and special situation techniques.
I believe that Greenblatt, like Ben Graham, started the project as a way to teach individual investors more than as a way to use for his proprietary funds (although he does use those ideas). He wanted to provide a simple to follow strategy for everyday investors to use that would be superior to an index approach.
The results of this test were published in his book The Little Book That Beats the Market. These results, needless to say, were astounding and surprising, even to Greenblatt himself:
Please remember that these are backtested results, and not guaranteed to continue.
The above is a chart I found on Jae Jun’s excellent site, which was reproduced from Greenblatt’s second edition of his book. The Magic Formula method of picking stocks averaged 23.8% per year vs a market average of 9.6% during the period from 1988-2009.
Magic Formula YTD Hypothetical Results
So far in 2013, the Magic Formula is the best performing strategy of all the hypothetical value strategies I track. I track a list of 30 “Magic Formula” stocks with market caps over $250 million, and also a list of the top 30 over $2 billion. These lists can easily be generated at Greenblatt’s Magic Formula Investing site. The smaller cap group is up about 42% year to date, and the larger group is up just under 40%. Here is a list of the top 30 Magic Formula stocks that were in the group at the beginning of the year (this is not a real money portfolio; just a hypothetical portfolio I track for fun each year):
Please remember that these are hypothetical results, without consideration for commissions, taxes, slippage, etc…, and not guaranteed to continue.
Both hypothetical Magic Formula portfolios are trouncing the S&P so far in 2013. Of course, they are just as likely to trail the market average by a similar amount over such a short time frame, I just found it interesting to note the fantastic results so