13

Background

Joel Greenblatt's book "The little blue book that beats the market" is based on the premise that he has developed a magic formula.

I am heavily skeptical of anyone who claims that they can beat the market, but he claims that his formula has historically beat the market (although he makes no guarantees about future performance)

As I understand it, the basic premise is to take advantage of the market's imperfect valuations to purchase two-three stocks each month that under-priced, and sell them after a year. He emphasizes that it is necessary to be consistent.

The only catch I can see is the cost of such high turnover.

As summarized by Wikipedia, here is the 'formula':

Formula

  • Establish a minimum market capitalization (usually greater than $50 million).
  • Exclude utility and financial stocks
  • Exclude foreign companies (American Depositary Receipts)
  • Determine company's earnings yield = EBIT / enterprise value.
  • Determine company's return on capital = EBIT / (Net fixed assets + working capital)
  • Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  • Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
  • Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  • Continue over a long-term (3-5+ year) period.

Question

Does this strategy really outperform the market?

  • 5
    The real question is whether it predicted its portfolio would outperform or did he just build a strategy that maps favorably to historical data points. If you give me the historical data I can find any number of strategies that worked in the past. – JohnFx Apr 8 '11 at 4:14
  • 1
    @JohnFx he developed a strategy and then tested it rather than selecting the best fit model. – David LeBauer Apr 8 '11 at 4:36
  • 1
    As others have said, the info is out there for everyone to use, it's simply a case of "packaging du jour" - and today's is Greenblatt. Bit like dieting pills, really. – gef05 Apr 8 '11 at 11:01
  • 2
    Remember that owning casino is more profitable than playing in casino. Trading is playing (even if formula is great) and selling books is owning casino. That guy became famous and books are sold well. – Andrey Apr 8 '11 at 13:53
  • 1
    Yes. And green jelly beans cause acne: xkcd.com/882 – barrycarter Apr 8 '11 at 14:08
20

While it is true that this formula may have historically outperformed the market you have to keep one important thing in mind: once the formula is out in the open, the market inefficiency will disappear.

Here is what I mean. Historically there have always been various inefficiencies in the market structure. Some people were able to find these and make good money off them. Invariably these people tend to write books about how they did it. What happens next is that lots of people get in on the game and now you have lots of buyers going after positions that used to be under-priced, raising demand and thus prices for these positions.

This is how inter-exchange arbitrage disappeared. Its how high frequency trading is running itself into the ground. If enough demand is generated for an inefficiency, the said inefficiency disappears or the gains get so small that you can only make money off it with large amounts of capital.

Keep in mind, as Graham said, there is no silver bullet in the stock market since you do not hold any data that is unavailable to everyone else.

  • @Gennaldly your point assumes that as soon as a good formula is available, people will use it AND that this would reduce the inefficiency. Even if 100% of investing were done this way, you would still be able to choose the companies that are most undervalued. The author also points out that few people have the discipline to stick with the plan because they are influenced in the short term by market fluctuations. – David LeBauer Apr 8 '11 at 4:00
  • 3
    You do not really need everyone to jump into the boat and go along with this formula. Even a tiny fraction of the market following this system will make picking the stocks harder and harder since the under-valued stocks will no longer be under-valued. This happened to many such systems in the past. If you can get a hold of the first 50 pages or so of The Intelligent Investor it lists quiet a few of these in the commentary. – Gennadiy Apr 8 '11 at 4:07
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    It tends to go in cycles. There are many reasonable investing disciplines or asset classes, but too many people piling into any of them can break them (even buy-and-hold indexing can break if everyone does it, though that strategy scales to more people than most). There's a price at which any investment is no longer a good value, and an investment strategy is really just another investment. As strategies get popular they often stop working, then they become unpopular and start working again, and round and round we go. (Only strategies that have some rational basis keep coming back perhaps.) – Havoc P Apr 8 '11 at 14:02
  • 1
    Also worth pointing out that said books only come out when the "magic" formula is about to run out of "pixie dust". So the profits shift from "I'm doing it" to "how I did it". – Mindwin Oct 31 '16 at 11:38
  • I think your response is generally applicable to formula investing, but I just don't see it applying to the magic formula. The magic formula is too imprecise. In addition to the discipline that @HavocP mentions in his answer (which I agree with), the very fundamentals of the formula can vary from one investor to the next. Market cap, timing, and quantity of stock picks chosen in that time can all vary from one investor to the next. – The Gilbert Arenas Dagger Feb 19 '17 at 19:54
7

I read the book, and I'm willing to believe you'd have a good chance of beating the market with this strategy - it is a reasonable, rational, and mechanical investment discipline. I doubt it's overplayed and overused to the point that it won't ever work again.

But only IF you stick to it, and doing so would be very hard (behaviorally). Which is probably why it isn't overplayed and overused already. This strategy makes you place trades in companies you often won't have heard of, with volatile prices.

The best way to use the strategy would be to try to get it automated somehow and avoid looking at the individual stocks, I bet, to take your behavior out of it.

There may well be some risk factors in this strategy that you don't have in an S&P 500 fund, and those could explain some of the higher returns; for example, a basket of sketchier companies could be more vulnerable to economic events.

The strategy won't beat the market every year, either, so that can test your behavior.

Strategies tend to work and then stop working (as the book even mentions). This is related to whether other investors are piling in to the strategy and pushing up prices, in part.

But also, outside events can just happen to line up poorly for a given strategy; for example a bunch of the "fundamental index" ETFs that looked at dividend yield launched right before all the high-dividend financials cratered. Investing in high-dividend stocks probably is and was a reasonable strategy in general, but it wasn't a great strategy for a couple years there. Anytime you don't buy the whole market, you risk both positive and negative deviations from it.

Here's maybe a bigger-picture point, though. I happen to think "beating the market" is a big old distraction for individual investors; what you really want is predictable, adequate returns, who cares if the market returns 20% as long as your returns are adequate, and who cares if you beat the market by 5% if the market cratered 40%.

So I'm not a huge fan of investment books that are structured around the topic of beating the market. Whether it's index fund advocates saying "you can't beat the market so buy the index" or Greenblatt saying "here's how to beat the market with this strategy," it's still all about beating the market. And to me, beating the market is just irrelevant. Nobody ever bought their food in retirement because they did or did not beat the market.

To me, beating the market is a game for the kind of actively-managed mutual fund that has a 90%-plus R-squared correlation with the index; often called an "index hugger," these funds are just trying to eke out a little bit better result than the market, and often get a little bit worse result, and overall are a lot of effort with no purpose. Just get the index fund rather than these.

If you're getting active management involved, I'd rather see a big deviation from the index, and I'd like that deviation to be related to risk control: hedging, or pulling back to cash when valuations get rich, or avoiding companies without a "moat" and margin of safety, or whatever kind of risk control, but something. In a fund like this, you aren't trying to beat the market, you're trying to increase the chances of adequate returns - you're optimizing for predictability.

I'm not sure the magic formula is the best way to do that, focused as it is on beating the market rather than on risk control.

Sorry for the extra digression but I hope I answered the question a bit, too. ;-)

  • What about wanting to beat (local) inflation, and (international) currency swings, over the medium term (10+ years)? – ChrisW Nov 30 '11 at 2:10
  • 1
    I would think of "adequate" returns as returns that are good enough for your plan (to meet your goals, such as retirement). But your plan has to be realistic (based on returns you're very likely to get, not returns you wish for). A realistic return assumption could be a little bit above inflation but not much above it. With a realistic plan (probably involves "save more, spend less"), you know you need $X to meet your goal. People often take risks to try to get 2X. But my opinion is maximize the chances of X. Paying attention to the potential for 2X will add risk of much-less-than-X. – Havoc P Dec 2 '11 at 5:41
  • 2
    Another way to put it: don't try to maximize the expected value (the probability-weighted outcome, which means if there's a 50% chance of $100 and a 50% chance of $50 your expected value is $75). Instead, one should maximize the chance of arriving at a certain threshold. A 50% chance of being well below goal is unacceptable, even if the average outcome reaches the goal. So my question for this little book strategy is whether in beating the market on average (sounds good), it adds a wider range of outcomes (bad). – Havoc P Dec 2 '11 at 5:53
7

GENIX was started by Joel Greenblatt back in 2013, so it is a real life test of the strategy. GENIX got off to a great start in 2013 and 2014 (probably because investors were pumping money into the fund) but had a terrible 2015, and lagging in 2016.

Since inception it has under-performed an S&P 500 index fund by about 1.90% per year. The expense ratio of the fund is 2.15%, so before expenses GENIX still has a slight edge, but Greenbatt is doing much better the fund's investors.

I think GENIX could be an OK investment if the expense ratio were reduced from 2.15% to around 0.50%, but I doubt the fund will ever do that.

5

Probably not. Once the formula is out there, and if it actually seems to work, more and more investors chase the same stocks, drive the price up, and poof! The advantage is gone.

This is the very reason why Warren Buffett doesn't announce his intentions when he's buying. If people know that BRK is buying, lots of others will follow.

  • 1
    except that each person is choosing 2-3 stocks from the top 20-30 on any given day, so there is constant turnover and there will always be a ranking of the most undervalued stocks. – David LeBauer Apr 8 '11 at 4:08
  • 3
    @david Sure, but as more people pile on to the strategy fewer stocks would be left with any head room. – George Marian Apr 8 '11 at 4:23
  • 1
    @David: If you get enough investors doing this, it doesn't matter. If ten thousand investors follow this strategy, the equivalent of 1,000 investors will be competing against you to buy the three stocks you pick (assuming everyone picks three, and that there's no preference between the pool of 30 stocks that the investors as a whole are favoring). – mbhunter Apr 8 '11 at 4:27
  • 1
    wouldn't you still need to divide 1000 by the number of trading days per month since there is no set date? – David LeBauer Apr 8 '11 at 4:34
  • @David: I still don't think this matters. The main point is that if a strategy appears to work well, it will attract more investors that adhere to that strategy, and then it will cease to work. If those 1,000 investors are making money, then more will come until the above-average rate of return goes away. Side note: if someone really does have a magic formula, it's unlikely that they'd be writing a book on it. They'd be using their formula to make far more. Only when enough people catch on do they write the book then. :) – mbhunter Apr 8 '11 at 7:28
4

In addition to other answers consider the following idea. That guy could have invented say one thousand formulas many years ago and been watching how they all perform then select the one that happened to be beat the market.

  • @sharptooth I am sure that he could have, except that he didn't. Furthermore, I would expect that he would have found many more than one (closer to 500). – David LeBauer Apr 8 '11 at 6:13
  • 2
    @David: Okay, but think about motivation. That guy wants to sell his book. – sharptooth Apr 8 '11 at 6:18
  • 2
    How do we know he didn't? – DJClayworth Apr 8 '11 at 13:59
  • 1
    Strategies chosen at random don't beat the market 50% of the time (or we'd all be rich) so it's more likely that only a few strategies out of a thousand beat the market. He picks one and publishes his book. But that approach unfortunately doesn't guarantee that the strategy will work in the future. – DJClayworth Apr 8 '11 at 20:46
  • 2
    the "magic formula" is just a fancy screen to try to get the best "value premium" (which is widely argued to exist). it isn't a random data mine. if you use a low limit on market cap you could get "small cap premium" too. the screen is more complex than a value index fund because it's trying to screen out some companies that are hard to analyze just looking at accounting numbers and also companies with low quality margins. it's perfectly logical stuff. – Havoc P Apr 11 '11 at 4:25

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