Book Review: Magic Formula Investing - The Little Book That Beats the Market

A friend recommended Joel Greenblatt's Little Book about a year back. It starts out sounding like a joke or some kind of a hoax but it should takeall of 1-2 hours to read the entire book and I strongly recommend it - both for adults and teenagers!

Before I proceed to review the Magic Formula, the following points represent my underlying investing philosophy:

1. The market is noisy (capricious) in the short run, efficient (values companies efficiently) in the long run. I believe in mean reversion, that is, temporarily undervalued stocks are likely to rebound back to their 'true' values.
   
2. Given my net worth, I don't see any value in paying someone to manage my money. As a result, I am not too excited by mutual funds. I prefer ETFs.
   
3. I'm too lazy to keep constant track of my portfolio and I hate transaction costs. I therefore like buy-and-hold approaches.
   
4. Diversification globally is goodness.
   

Written in a tongue-in-cheek style, Greenblatt appeals to the child in you, quite literally, to educate you on time tested concepts of value investing. Overall a good book targeted at the mainstream public that not only builds an appreciation for the rationale behind value investing but also gives you an almost mechanical method to invest using the "Magic Formula." Here's a quick summary of MFI...

Greenblatt's basic theory is that its pretty hard for most people (and especially individual investors) to reliably forecast future growth. He therefore recommends that the individual investor simply focus on buying good companies at a good bargain. Good, as defined by MFI, is used for a company with a high ROIC (return on invested capital) and you separate a good bargain from a bad one by looking at the Earnings Yield (EY).

With ratios, its basically garbage in, garbage out. We need to look under the numbers and see how they're calculated. Greenblatt defines them as follows:

ROIC = EBIT/(Working Capital + Fixed Assets),
where EBIT: Earnings before Interest & Taxes
EY = EBIT/EV,
where EV, the Enterprise Value = Market Cap+Net Interest Bearing Debt

The reason he adds back debt to EV is to make sure the Earnings Yield is not affected at all by the debt-to-equity ratio. He also wants to compare companies at different debt and hence tax levels.

The basic steps to building an MFI portfolio is as follows:

1. Create a composite ranking of companies by ROIC and EY.
2. Buy stocks for 20-30 of them (you could do it gradually)
   
3. At the end of the year, review and:
1. sell losers 1 day before before the end of the year
2. sell winners 1 day after the year end
3. replace losers with new companies, go back to 1.
   

Based on back testing (17 years), the magic formula has yielded annual returns in excess of 30%. There hasn't been any 3 yr period with negative returns.

This method has some nice attributes: almost mechanical, focus on the portfolio and not individual companies/stocks, not much churn. Note that he recommends this for average individual investors who are not into doing a great deal of diligence on the companies.

Here's the best part. There's an MFI website, www.magicformulainvesting.com, which allows you to screen companies based on the ROIC, EY criteria.

ROIC or ROE or ROA?

ROE is return/book value of equity. This doesn't take into account the debt capital. ROA is return/book value of assets, which can include accounting gobbledygook like goodwill. In addition, Greenblatt removes uninvested cash from assets, and adds payables since in effect they are an interest-free financing of operations.

Not many have been able to reproduce the MFI screens. If you understand exactly how he calculates ROIC, do let me know!

Commissions?

As a Schwab customer, I'm looking at transaction costs of 25 (size of my MFI portfolio) times $12 = approx 300-600 depending on when you bought and when you started replacing them. Check out www.interactivebrokers.com or www.foliofn.com. I tend to holder longer than 1 year.

No Utilities, Financials & ADRs

To keep things simple the vanilla ROIC and EY don't apply to the capital structure of financials, possibly because they are usually highly levered.

Isn't Earnings an accounting artifact?

Earnings could be inflated temporarily by creative accounting! An equity from the MFI screen could be the subject of earnings restatement. I don't believe vanilla ROIC or EY can guard against that. Greenblatt remarks that sophisticated investors such as himself can calculate forward-looking versions of these parameters.

Macroeconomic factors

Capital intensive industries tend to be cyclical. The MFI screening criteria doesn't seem to account for business cycles that may affect industry fundamentals.

Micro ($50m-$300m) vs Small ($300m-$2b) vs Mid ($2b-$10b) vs Large cap ($10b+)

In my experience micro and small cap pickings from MFI have shown a lot of volatility AND negative returns. My recommendation is to stick with mid & large cap.