Is The Acquirer’s Multiple The Next Magic Formula? by Lukas Neely, Enlessrise Investor
Editor’s Note: This is part of an interview originally published in Value Investor Confidential (June 2015 Issue).
There has been much debate and research conducted on a NEW screen and systematic way to approach value investing. Those who know of, or already use, the Magic Formula may be interested to learn that there’s a “new kid” on the block. It even follows a process similar to the Magic Formula — except The Acquirer's Multiple has provided better returns versus that of the Magic Formula.
Not only did the Acquirer's Multiple beat out the Magic Formula – it trounced the overall market. See the figures here.
As the names implies, The Acquirer's Multiple is the valuation ratio financial acquirers use to find attractive takeover candidates.
We had the chance to sit down with Toby Carlisle, creator of The Acquirer's Multiple, to discuss in-depth his new formula, how he uses it to produce out-sized returns in the market, and who he is as a person and investor. Enjoy!
VIC: So Toby, explain to us The Acquirer's Multiple™ and how it came to fruition?
Tobias Carlisle: Joel Greenblatt’s Magic Formula is an original, very simple quantitative value investment model. The idea is that you buy something very cheap. To accomplish this by following 4 steps:
- You rank every stock on its cheapness using earnings before interest and taxes on enterprise value (EBIT/EV)
- Then you rank everything on its quality, which is return on invested capital (ROIC)
- And then you find the two and sum the rankings together.
- Then you buy the best 30 equally.
Theoretically, this will give you the cheapest and the best securities.
It’s modeled on Buffet’s wonderful companies at fair prices approach to investing. And it works really well. It tends to beat the market. It has periods of under performance, but it’s a very good strategy.
In the process of writing Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, I had this idea in my mind when I read James Montier’s paper six years earlier (The Little Note That Beats the Markets). He found that some markets that were just using the earnings yield (earnings for interest in taxes and enterprise value), tended to outperform the whole magic formula. So we tested that idea in the States and we found that that was in fact the case. What was most interesting about this finding, was that not only did it outperform in a raw basis, but it outperformed in a risk-adjusted basis. And by risk-adjusted, we mean volatility adjusted using the Sharpe Ratio.
This simple strategy beating the Magic Formula on a risk-adjusted basis really fascinated me – it was very interesting. So that was the question I got the most after writing the Quantitative Value book. People were asking, How is it possible, that it is, in fact, the case?”
As a result, I wrote Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations. I wanted to describe the reason that it does so well. And the answer is mean reversion.
You get mean reversion in good stocks and businesses and you get it in bad businesses. As we know, mean reversion dictates that things go back to normal. So businesses that have been operating really badly, microeconomic theory says that competitors will leave the industry. And whoever remains can earn fairly good money for a period of time.
Similarly, when businesses are in a great operating environment, competitors come into the industry and eat up some of those abnormal profits. Overtime they tend to get pushed back to average profitability.
We can show that empirically. Michael Mauboussin has done some great research where he basically shows there are very few companies that resist mean reversion. Of course, Buffett is looking for the ones that resist mean reversion.
I just have to accept that I don’t have the brains to do it — I can’t find them. So, the 4% of businesses that resist mean reversion means that there are 96% of businesses that don’t. And I can fish in the 96% that don’t and I’ll occasionally by some of the 4%. I’m just trying to buy them all incredibly cheaply.
The trick that I use is called The Acquires Multiple which is basically operating earnings on enterprise value. So it’s basically half of the magic formula. And I do a few other things just to pick out the outliers or earnings manipulators.
Operating earnings is functionally the same as EBIT, but it’s calculated in a slightly different way.
We start from the top of the Income Statement and work down — rather than adding back. We’ll use revenue, minus cost of goods sold and SG&A. So it’s basically giving the same answer as EBIT. It’s just constructed at the top of the income statement going down.
The reason I do that is because there is more room for manipulation the further down the Income Statement you go. Of course, you can start from earnings and you can add back in interest and taxes and depreciation, but I think the numbers are more open to manipulation at the bottom of the statement.
You can still get manipulated numbers at the top but it’s nowhere near as bad at the bottom. All you have is a revenue number, you back out of the COGS and SG&A — and that gives you operating earnings.
VIC: With regards to your back-testing, how to do account for survivorship bias?
TC: If a company’s fails, they keep the information in a database. So you can buy a company that has failed.
There are other things that we do as well. We lag the data by 6 months. And we use the 10K. So we take the ordered financials and then you wait 6 months. So if there’s any kind of revision in the ordered financials then it should be out and known to the market. And then you instruct the back tester to buy on July 1 or June 30, looking back at the 10K from the year previous.
So it’s a robust test.
What is kind of interesting is, if this year is Y and you’re buying in June. Meaning you can buy Y -1 and you’ll get the results from the book (Quantitative Value). If you still buy, using Y -2 data, you still get a similar answer.
It doesn’t really make much difference how lagged the data is because the business’s performance persists and you’re just buying at a discounted value. So the lag can be made longer and you still get comparable performance. And I always thought that was really interesting. I’ve never really seen it anywhere before.
VIC: What are the top three things an investor should focus on the most to help keep their edge?
#1 – Buy undervalued companies,
#2 – Stay fully investing in them, and
#3 – Don’t’ get discouraged if you have periods of under performance.
Periods of bad performance normally lead to periods of good performance. For example, if you were buying in early 2000 — value was not working during that period. It would have been tough to apply a value investing approach, but there