Here are my notes on Joel Greenblatt's talk last night (x-posted from TMF).
- He wrote the book because many people find the stock market intimidating. He wrote his first book ( _You Can Be A Stock Market Genius_ ) to help the average investor, but when he began teaching he discovered that the book was written at the “MBA level” and wasn't really useful for the average investor. His intent this time around was to write a book that could be used by people who can't read financial statements.
- When he went to Wharton, Efficient Market Theory was the theme. He was taught that investing was “too hard” and that he should only buy index funds
- In reading on his own he discovered Ben Graham and his discussion of “Mr. Market”. He noticed that, despite the idea that markets were supposed to be efficient, companies would vary widely in price with no real change in fundamentals. He saw that Ben Graham was able to make money over a number of years simply by buying companies that traded for less than their liquidation value (the so-called “Net/Nets”). The only problem with Graham's method was that Net/Net was an absolute value that could be easily calculated. Once the markets turned up, and people finally caught on, these went away.
- For Greenblatt, the next evolutionary step in value investing was Buffett's insight that you should look for good companies and try to buy them cheaply. This is the style he uses. In his fund he tends to hold about 8 companies at a time.
- He mentioned the founding of valueinvestingclub.com, targeted at value oriented professionals. He says he did it mostly “for his own amusement” at a time when value investing was very much out of favor.
- He gave a brief review of the methods covered in the book, which I won't go over here. He did spend a fair amount of time on the charts which demonstrate that, no matter how you look at it, buying high ROC companies at low earnings yields will give superior results over time. The featured graph showed results for the magic formula divided by decile. It was a clear progression from top to bottom.
- He closed by addressing the question of whether publicizing this formula would ruin it or, as he put it, “why am I such a blabbermouth?”. His answer, as in the book, is that people will bail out during the inevitable periods when the formula underperforms. As the underperformance continues people will review the stocks they are holding and start looking them up in the paper. What they read there will be enough to drive many away. He told a couple of anecdotes to demonstrate his point. One he had described in the MFI book - a money manager who did an extensive study of what has worked historically, wrote a successful book about it, and then set up a mutual fund based on those strategies. His funds underperformed badly. Finally he threw in the towel and sold the funds. Needless to say, since then the funds have been among the top performers. The other anecdote was about a friend, a value investor and “the smartest guy I know”. This guy set up funds and followed his principles. For the first few years, he also underperformed badly. He believed in what he was doing, but many of his clients lost faith. One client, when he looked at the list of stocks in his quarterly statement reportedly said “Don't you read the paper?” He managed to hang on and is now a top performer, but he almost went out of business. In other words, good companies get cheap for a reason. It's easy to buy them when they are high and tough to hold them when they are cheap. Without constant positive reinforcement, which this strategy will not give you, it is very difficult to stick with these methods.
There was a question and answer period for which my notes are a little sketchy, partly because I was standing in line to ask my questions, and partly because the answers to a lot of the questions asked are in the book. Some highlights:
- There was the inevitable question as to whether he liked stocks X and Y. In this case stocks X and Y were Ford and GM. He said that they were not the type of company he followed because of their low ROC, and they were unlikely to show up in the magic formula. He named some companies that do have high ROC and which he implied had interesting prices – Microsoft, Wal-Mart and Gap. He also commented that small cap companies seem to be relatively high priced right now but there are a lot of quality large caps at attractive prices. Not exactly a great revelation but it's always nice to hear one's belief's echoed by someone you respect.
- He was asked whether there were further tweaks that could improve the strategy. He intimated that he does refine it, saying “I said I'm a blabbermouth but I'm not disclosing everything”. He believes the part he is sharing is pretty darn good.
- I asked whether commissions were included in the historical study (they weren't). I also asked about rebalancing strategies for stocks you already own. For example, if I own $5000 of American Eagle at the end of the year, and it is still on the list: 1) Should I keep the position? 2) If I do, and assuming reasonable commissions, at what point does it become not worth it to change? Should I buy $10 worth if my new target position is $5010? If not, how about $50 at $5050? And so on. The answer was that it doesn't really matter, set up whatever cutoffs you want, because in the long run you'll do well regardless. As a side note, he mentioned in answer to a different question that, if you have enough money to keep the yearly fee at a reasonable percentage, Folio.fn (which he said he is not associated with in any way) is a good place to implement the Magic Formula. I haven't used them, but with their ability to handle fractional shares that does make sense.
- I also asked about situations where the numbers that drive the formula can't be relied on. I gave the example of current MFI stock Patriot Scientific Corp, which looks like it has a toxic convertible (meaning that any calculation of market value is basically worthless). I also gave the example of companies who are heavy options abusers and who have to constantly spend money to buy back stock to feed their beast. The answer was that this is a legitimate issue, but that problems like this existed over the course of the period studied and the strategy still worked.
This talk was aimed at novice investors, and that's who the strategy is aimed at. Several times, Greenblatt advised people not to read the appendix that explains the calculations, and emphasized that the vast majority of people should stick to the Magic Formula or index funds. In his opinion, you shouldn't be an active investor unless you're willing to put a lot of work into it. His main theme during the Q & A was to not overthink the Magic Formula. As he put it at one point, “You could call it the 'Don't try too hard' method of investing”.
I wouldn't be surprised if the earlier poster is right and the implementation of the formula on magicformulainvesting.com contains some tweaks that aren't covered in the book. I get the feeling that Greenblatt's basic philosophy is that if you're one of the people who should be taking this to the next level, you should be able to figure it out on your own. If you're not, the book and the information on the web site should be all you need.
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