Value Investing

Magic Formula and Other Quant Value Formulas: Time To Let Computers Rule?

Let me say that the following few sentences only represent my humble opinion. There are many smart, talented, and successful practitioners that participate in the field that I am about to comment on…

(Editor side note: unlike many who take pride in saying things such as “I tell it like it is”, or “I don’t care what others think”… I happen to dislike offending others and I do care what others think, but evidently I’m in the minority here. I certainly have my opinions, I’m not a fan of “political correctness” or anything like that, and I enjoy debates, but I don’t care about drawing attention to things that I disagree with when the sole purpose is to generate an argument.)

Rule #1: Don’t Lose Money

Having attempted to soften the blow from a very passionate crowd (many of whom I’m friends with), let me say that I’ve never been a big fan of letting a computer screen or “magic formula” tell me what stocks I should own. I think of risk management as the most important area of investing, and in my opinion, I feel that I would be taking on far too much risk to let a computer tell me what businesses I should own. For some reason, the stock market has always lent itself to this type of behavior. Probably because of all of the data, liquidity, and easily ascertainable financials. Buying and selling things based solely on mechanical formulas doesn’t really occur in private equity or business in general. I’ve never come across a successful business mogul who every December 31st liquidates all of his businesses, and then on January 1st acquires a whole new list of businesses that happen to be available at some low multiple of earnings, or worse yet–because those businesses happen to have gotten more expensive to buy in recent months (i.e. momentum).

It’s comical to imagine such a scenario. Imagine Sam Zell liquidating his real estate holdings at year end, and then the next day arbitrarily buying equal stakes in the 30 buildings in Chicago that trade at the highest cap rates (lowest P/E, or to be precise–EV/EBIT), and repeating that process each year. Imagine how shareholders would react if John Malone–instead of buying a stake in Charter and going after Time Warner Cable–abandoned his circle of competence and announced that Liberty Media would now be focusing on buying and selling each year the 50 stocks with the lowest price to book ratios because that strategy has performed quite well in a backtest.

His shareholders would likely revolt–and not because he chose to focus on low P/B instead of low P/E, EV/EBIT, or P/S. They would be upset because it wouldn’t make much sense. They would collectively feel that it doesn’t make much sense to abandon experience, knowledge, understanding, value principles, and common sense decision making–ingredients that resulted in outstanding shareholder results (Liberty Media is Malone’s holding company whose former parent–TCI–produced multi-decade shareholder returns of around 30% per year with Malone at the helm).

So if this type of strategy is comical when it comes to business investing, why is it so commonly accepted and respected in stock market investing?

This is a question I’ve thought about a lot… again–I respect many of these so-called “quants”. Some of them, such as Joel Greenblatt–has indirectly taught me an incredible amount about investing and I will likely be permanently indebted to him. Greenblatt is interesting because he actually left a value investing strategy that was ultra successful (40% or so per year for 20 years) in favor of his “magic formula”. I was always amazed that he made the switch, and would love to know exactly why, but both of his systems seem to give him great success (although the results of his original strategy–by his own admission–will always be superior).

Why Not Follow the Quants? 

So most of these quants are extremely smart, and many have built thriving asset management firms with excellent results so far. And the tests are convincing… owning low P/E or low P/B works over time. Even momentum works… in most of the backtests it is basically as strong as value. So why not try to emulate the quants? Wouldn’t it be easier to just let a computer program tell you what stocks to buy at 5pm on December 31st, issue buy orders for January 2nd, then take the rest of the year off? Well… even the quants will tell you it’s not that easy. They work much harder than this. Jim Simons (one of the most successful hedge fund managers of all time and a genius mathematician turned quant hedge fund billionaire) once said that as soon as you develop a system, someone else is already working on the same system and so you always have to be one step ahead–thus his reasoning for hiring 100 or so of the smartest math minds he could find.

But what about “quant” combined with “value”? This doesn’t take 100 PhD’s… just some common sense principles, a computer screen, and a healthy dose of behavioral fortitude (patience) to stick with it. After all, we’re taking common sense principles and creating a structure that forces us to stick with it right? Greenblatt has often said that simple value investing strategies work because sometimes they don’t work. If you can just stick with it, you’ll beat the market, etc… Yes, I think that probably is true, but the problem is most people don’t stick with it.

I personally have spent a lot of time considering these types of strategies over the years. And I think I have the temperament to stick with it (who doesn’t think that, right?)… However, the issue that I could never get comfortable with is investing in a business (or basket of businesses) that I knew absolutely nothing about. The results look great when assembled in a table, but take a look at the most recent magic formula screen, there will likely be a number of businesses that you know nothing about and some you have never heard of. That is the biggest issue for me, and one that I could never rationalize.

I think that over time, most of these systems will end up doing quite well, but when it comes to my money and that of my investors, I prefer to stick to owning things I know something about. I will rely on the same value principles that Graham, Schloss, Buffett, Greenblatt espouse–the same basic principles the value quants use–but I’ll add a layer of common sense and understanding to the equation. This is far from a guarantee that my strategy will do better… in fact, many of the quant systems will likely prove a very tough test. And it’s amazing how well a simple system such as Greenblatt’s magic formula has done. But in the end, that’s all we’re really doing, right? We’re just trying to buy good businesses (high ROIC) at cheap prices (low P/E). So it shouldn’t be surprising that it works.

I guess what I’m doing is simply using the principles and just ensuring that I understand what businesses I own.

But I do believe it is less risky–and more common sensical–to understand something–albeit not everything–about the businesses you own. Adding common sense and logical decisions with tried and true value investing principles seems the best combination to me. 

But again, this is just my opinion.

Enough Theory–Let’s See Some Quant Results

Without further ado, and with the understanding that showing these outstanding results might seem contradictory, I’d like to show the results of some very simple value investing strategies from 2013. For fun, I keep track of a few simple value portfolios each year. These are just hypothetical portfolios, and I keep them more or less because I love data. This is the first year I actually kept them on a mock portfolio on Finviz. These are not portfolios that I manage–these are only hypothetical results that are gross of costs such as commissions, fees, slippage, taxes, and other transaction costs that one would incur in a real money portfolio. But nevertheless, I was astounded by how well some of these simple strategies did in 2013. Obviously it was a banner year for the market–best since the mid-90?s. But take a look at how some of Greenblatt’s ROIC (“magic formula”) strategies did:

Hypothetical Portfolios

 (disclosure: these are hypothetical results-not real money portfolios)

Again, these are just hypothetical passive portfolios that I track for fun. The magic formula had one of the best years in the history of the backtest going back to 1988 (although there were a few years that surprisingly surpassed this one). The index portfolios are the results of simply taking the S&P 500 and taking the cheapest decile (or the cheapest third of the Dow). The highlighted portfolio takes the cheapest S&P decile (50 stocks within the S&P 500 with the lowest P/E ratios) and then takes the 10 stocks from that group with the highest return on capital.

So it was a good year for quality and value as measured by low P/E and high ROIC. My Greenblatt hypothetical portfolios simply took the top 30 stocks in the screen at the beginning of the year. Here is a list of the 10 stocks within the S&P low P/E decile with the highest returns on capital (as measured by taking current assets plus net fixed assets less current liabilities) along with their 2013 total return including dividends:

Highest 10 ROIC Stocks 2013

Wow, what a list to throw a dart at in 2013… returns on each stock ranged from +15% to +127%. Unlikely to be matched anytime soon.

These are tough results to beat, and I think that if I kept track of these for the next 25 years, we might not see a year as good as this one for most of these portfolios. In the end, I enjoy checking these once a year–more just to see how “value” does vs. the market, and I think these portfolios would actually represent better than average results over time compared to the S&P. My objective is to do better than the average and better than these portfolios over time, but I refuse to waver from my focus on risk management, and that requires me to do some thinking. Some feel that because of their very nature, it might be less risky to follow these types of automated strategies. To each their own, and for those that follow these strategies, congrats–you certainly had a great year!

Via: basehitinvesting