15/11/17

How to invest like...the hedge fund manager with a magic formula

(The Telegraph) -- Few fund managers are capable of explaining investing in simple terms. Most prefer to keep what they do a mystery - something that's best left to a handsomely paid professional.

Wall Street hedge fund legend Joel Greenblatt is an exception. He founded Gotham Capital - now Gotham Asset Management - in 1985, and has been a professor at Columbia Business School since 1996, specialising in "value" investing.

According to Frederik Vanhaverbeke's 2014 book Excess Returns, Mr Greenblatt managed to achieve a compound annual return of 45pc over 19 years.

By comparison, the famed Fidelity investor Peter Lynch managed an annual rate of 29pc over 13 years, and Warren Buffett has managed a 20pc plus average, although that has been sustained for more than 50 years.

Mr Greenblatt has also written a number of books, most notably the bestselling The Little Book that Beats the Market.

In it, he outlines his so-called "magic formula". It's a fancy name that at its core has a simple goal: buy good companies at bargain prices. The beginning of the book is also an entertaining, simple guide to understand stock market investing.

He explains that while markets tend to value companies fairly in the long run, over the short term they can be wildly irrational, and value stocks at both depressed and inflated prices. That presents opportunity.

Formulas that claim to have found a secret recipe for investing are often problematic. Many theories claim to show astonishing performance when tested with historic data, only for their apparent infallibility to be thwarted by a shift in the investment landscape. Others are simply too complicated to be easily used by an ordinary "DIY" investor, or require inaccessible data.

Investors can also lack the patience and discipline to stick with this type of numbers-based investing through rough periods, and diverging from a system is usually where things go wrong.

However, writes Mr Greenblatt, "If a formula worked all of the time, everyone would use it, and it wouldn't work" as there would be no bargain stocks. He argues that the inability of many investors to stick with a formula allows it to work for those who do.

The beginnings of value investing, and Mr Greenblatt's formula, start with famed investor Benjamin Graham.

His own formula aimed to select companies that were valued so low that the proceeds of a fire sale of their assets would be greater than the valuation. Mr Graham managed a 21pc annual return over 20 years, according to Excess Returns.

"Unfortunately, the formula was designed during a period where many stocks were priced cheaply," wrote Mr Greenblatt. His formula is a development of the same idea.

Taking the US stock market, the magic formula involves ranking companies on "earnings yield" and the return on capital that they are able to generate. The idea is to identify strong companies and then choose only the cheap ones.

Return on capital is a measure of the returns a business can generate by investing, in new equipment or store locations for instance.

Mr Greenblatt's view is that a business's ability to generate a high return on capital, even for one year, means that there is something special about that company, "otherwise, competition would already have driven down returns on capital to lower levels".

That takes care of the "good company" part of the formula. Earnings yield, which is a valuation metric, then makes an assessment of whether or not firms are cheap.

For most people, he recommends screening for companies that are $50m (£38m) or $100m (£76m) in size or larger. The companies are then ranked in each category, with one being the best. The ranking on each measure is then combined, and the lowest combined score gets the top spot.

The aim is then to buy the 20 to 30 highest-rated stocks, based on the combination of those two measures, and hold each one for a year.

To get started, Mr Greenblatt suggests buying five to seven stocks every few months, until a portfolio is built up, then changing them out as each holding reaches a year old.

He has set up a website, magicformulainvesting.com, which allows investors to screen for stocks based on his specific methods.

However, both the formula and screening tool have been developed for the US stock market.

Those aiming to apply this methodology to the UK or another market have to improvise. He suggests that those using other screening services should use a combination of return on assets (in place of return on capital) and price-to-earnings (p/e) ratios, in place of earnings yield.

He also adds a few more rules. These include eliminating all utilities and financial stocks, leaving out firms with ultra low p/e ratios of five or less (which indicate unusual data), and taking out companies that have released their earnings in the past week.

He also advises investors to eliminate all foreign companies, but that too is aimed at investors in the United States. This is not, he says, a method to be used to pick individual stocks.

In his hedge funds he uses the basis of this formula, but then includes more complex elements, such as predicted future earnings for the next three or four years.

His view is that those who don't have the capacity to carry out such analysis "have no business investing in individual stocks".

"Even professionals have a hard time making accurate earnings predictions for individual companies," he said.

Instead, the magic formula effectively picks 20 to 30 stocks at a time in aggregate, and captures the average return of those stocks.

This will go against the natural inclinations of many investors. The screen is likely to generate some stocks that, if assessed individually, investors would normally avoid.

How has the formula performed?

The testing carried out on the formula by Mr Greenblatt has also all been in the US. No one else has been able to reproduce his results.

From 1988 to 2009, the strategy returned an average annual return of 24pc, compared to 10pc for the S&P 500 index, according to Mr Greenblatt's update to his book in 2010. That would have turned a $10,000 investment into more than a million dollars.

He freely concedes that the formula doesn't work all the time, and there can be months or years when it fails to perform.

Whether or not an individual investor could have replicated this exactly is difficult to say. It's unclear, for instance, if dealing costs have been included, which would significantly eat into returns for a smaller investor, given that the strategy requires switching out of all 30 shares each year.

Stock screening service Stockopedia has created a replication of the magic formula screen, which it has applied to Europe and the UK too.

Over the past year, the UK version has returned 24pc, and over six years it has returned 62pc, for an annualised return of 8.4pc. That is still significantly higher than the FTSE 100's 40pc return over six years but not as dramatic as the US results suggest.

Recent performance has been stronger in Europe - including the UK. Over one year, it has returned 31pc, over two years it has returned 73pc, and in just over four years it has returned 89pc, for an annualised return of 15pc.

There's a downside

A clear downside to this strategy is that if the whole of a market is expensive - as many are concerned is now the case - there are very few bargains left to buy.

Mr Greenblatt's answer to this potential flaw is that if stocks are split into 10 groups based on their magic-formula ranking, the top group in his test has been shown to outperform the second, the second the third and so on.

So even if the whole market is expensive, the top-ranked magic formula stocks still do better.

Remember too, that the formula was devised before the era of ultra-low interest rates flooded markets with cheap cash.