Joel Greenblatt: A Magic Formula by SG Investor
Many should be familiar with The Little Book That Still Beats the Market by Joel Greenblatt. It was an experiment conducted by Greenblatt in attempt to discover if Buffett’s investment strategy could be quantified. Just based on the fact that Greenblatt being regarded as one of the best ‘special situations’ investors in his generation changed his entire investment strategy after this experiment is something that should propel every value investor to take a second look at this investment strategy.
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.
Warren Buffett, Shareholder Letter 2000
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
In the nutshell, the results of this experiment were so impressive that in 2006, Greenblatt named this strategy quantifying Buffett investment strategy as the Magic Formula and wrote the book The Little Book that Beats the Market. Greenblatt claims returns in the order of 30.8% per annum against a market average of 12.3 percent, and S&P500 return of 12.4 percent per year.
The Magic Formula:
Is the Magic Formula truly as magical as it appears?. Through much research, one would understand that with his method, Greenblatt did not discuss in granular detail regarding his method of studying the performance for such a valuation methodology. Furthermore, there is the issue regarding the reliability of the backtest performed by Greenblatt. Many have tried to simulate the Magic Formula, yet their performance were no where as close to that shown by Greenblatt (Read). ClariFI quants were the only ones that came close to replicating Magic Fomula’s results of 28% versus 30.8% respectively. The difference in performance was argued to be due to how Greenblatt actually defined his excess cash. Yet even that said, no one knows how such a formula would perform in the real world outside the database.
Is this to say that there isn’t any alternative quantitative method? While to date I yet to have seen one that is able to totally replicate Buffett’s investment strategy, it does not mean there aren’t any quantitative methods to improve our odds. We use quantitative methods in our screen to discover cheap stocks before drilling down into the qualitative aspect of the company. Such an approach though slightly more tedious, it is definitely better than a pure quantitative approach in my opinion. For good quantitative metric would be using the enterprise multiple (EBITDA/Enterprise Value). Furthermore, it has shown to be one of the best multiples, whose performance beats all other price ratios (Read).
Breaking down the Magic Formula, it only depends on 2 components – EBIT/Enterprise Value and Return on Capital. Looking at the research paper by Gray & Vogel, one would note that they performed all analysis with EBIT/TEV in place of EBITDA/TEV and find nearly identical results. The question remaining would be how much does ROC add to the outperformance? Montier performed a research on this and we would observe below the performance of a portfolio based on a pure EBIT/TEV followed by EBIT/TEV + ROC.
Adopting a method with ROC, a metric that measures the ‘quality’ of the company is advantageous in the sense of ‘career defence’, to put it in Montier’s words. With both methods, we can see that a bubble is visible between the top and bottom deciles. However, with the ROC component, it prevents the underperformance we notice within the first 8 years before the value decile caught up with the glamour. Whilst the performance results are lower, however, at the very least the fund manager adopting such a strategy would have been able to keep his job. (Read)
Ultimately, the question would be should one adopt such a quant-like investment strategy? I know for a fact that many would disagree with such an investment strategy. With investing, it is not just a pure numbers game. There are so many elements such as assessing management, relationship the company has with their suppliers and customers, hidden assets etc. Indeed, I would agree that such checks have to be done. However, the divergence would be do you wish to be buying a great company at a fair price or an average company at a cheap price. With the former, many questions would be asked in determining what makes that company great and how did you arrive that at the current price, it is fair. Yet, with the latter, I find it easier to determine that it is an average company and that it is cheap. Hypothetically, one example would be a company trading at EV-to-EBITDA ratios of 1.0 – 2.0x, I can definitely say with certainty that it is cheap. True, I am unable to say how high such a stock could go. However, I am certain that there is sufficient margin of safety. At such valuations, it is like the saying that you need not know the man’s exact weight to know he is fat. To sum it up, while I am rather skeptical regarding the Magic Formula, I would say that I am more pro using a more quantitative investment strategy followed by a qualitative analysis.
Quantitative Value Investing – as how Gray & Carlisle named such an approach.