[Almost About to Finish Term 4, I figured I'd clear out my backlog on the recap of Term 3!]
If there is only one thing I could say about Term 3, that would be "Whew! Its done." With about 3.25 credits--that's 4 1/2 credit courses, one 1/4 credit course and a 1 credit course--it was a lot of awkward context switching. Add to the mix your day job that pays the bills and occasional family considerations ;-), it got real messy.
My classmate Chairman P has a few posts on Term 3. Here's a funny poem and one on how you age faster at Wharton, especially during Term 3.
My take on the courses this past term:
Corporate finance (the 1 credit course) was an absolute delight. Prof Percival was great at de-quantifying finance; in other words, a good deal of time was spent in class trying to use financial analysis to drive strategy, product mix, cost structure etc. In contrast were the exams, which were mostly quantitative. Calculating NPV's by hand sure seemed like a lot of drudgery... The case write-ups were lesser binary in approach - we had the opportunity to understand a business problem, take our time, use Excel to analyze the data and then finally present a nuanced view point - not just numbers.
Marketing Management was like an introduction to marketing - basic frameworks (5Cs - 4Ps, Segmentation Targeting Positioning - STP etc), basic marketing math - describing the economic value to the customer (EVC), using EVC to set prices, figuring out break-even volumes, sizing up markets (for both volume and profitability) etc. While many of the concepts were tribal knowledge for many of us in the industry, it helps to have frameworks and a strong quantitative bias (only to be expected at Wharton) towards marketing initiatives. I particularly enjoyed Prof Bell's classes and especially his liberal references to marketing literature during his lectures.
For a 0.5 credit course, Marketing Strategy was a ton of work. Most lectures were case based. In addition to preparing for the cases, we had to work out the marketing math (like ad budget, price, market sizes etc) and enter the data into an online system. We spent a great deal of time messing with a market simulation system (called Sabre), which had algorithms that simulated typical market dynamics. In the later part of this course we looked into life-cycle of markets/industries; I think that may be a nice segue into Competitive Strategy - something we'll be looking in Term 4.
I learned a great deal of new concepts in the other two 1/2 credit courses: Matching Supply with Demand, and Managerial (or Cost) Accounting. I have never worked in manufacturing; I enjoyed learning about the type of issues one needs to be aware of with inventory management, use of different supply chain topologies, distribution strategies etc. I would say the workload was medium. Managerial Accounting was the last 1/2 credit course and it whizzed past most of us! Excellent professor and very pertinent material on inventory valuation, internal performance measurement, assigning costs to products etc. Especially in this day and age of corporate cost cutting, managerial accounting certainly teaches you what to focus on when you are looking to cut costs, and the right questions to ask when someone claims s/he cut costs.
Finally, a quick word about the course on communication. The intent is to get you comfortable with various forms of corporate communication - addressing employees, the press, managing crises etc. If you are not a good speaker already, I guess the course could help. But I have to say that its certainly not a conducive environment to prepare and practice a speech, especially when your communications class starts at 630pm or 7pm and goes on till 9. It makes even lesser sense given that you probably had two or three deliverables on that very day and have been sitting in class since 9am!
Tuesday, April 24, 2007
Tuesday, March 27, 2007
Churchill Club's 9th Annual Top 10 Tech Trends Debate
Way too many balls in the air. Way too much context switching between work, family, marketing finals, marketing simulation (Sabre), cost accounting assignment etc ad nauseum. I tell myself not to forget the larger goal - to be an entrepreneur or be involved with entrepreneurship in a significant way. I couldn't resist the idea of going to Churchill Club's 9th Annual Top 10 Tech Trends Debate today.
UPDATE: Pointer to SJ Merc Review of the Event.
The basic format of the event was that the moderator or a panel of star VCs would make a prediction. There would be a short debate at the end of which the audience gets a chance to wave a green card or a red card for the prediction.
The VC panel consisted of John Doerr (Kleiner), Steve Jurvetson (DFJ), Roger McNamee (Integral Capital Partners), Joe Schoendorf (Accel Partners). Tony Perkins from AlwaysOn was the moderator.
The top trends from my notes. I've tried to annotate who mentioned the trend.
UPDATE: Pointer to SJ Merc Review of the Event.
The basic format of the event was that the moderator or a panel of star VCs would make a prediction. There would be a short debate at the end of which the audience gets a chance to wave a green card or a red card for the prediction.
The VC panel consisted of John Doerr (Kleiner), Steve Jurvetson (DFJ), Roger McNamee (Integral Capital Partners), Joe Schoendorf (Accel Partners). Tony Perkins from AlwaysOn was the moderator.
The top trends from my notes. I've tried to annotate who mentioned the trend.
- Mobile Devices: There are going to be many more design centers for devices, requiring more "belt space" [Roger McNamee - RM]
- FCC will approve at least one new broadband network in the next year. More broadband freely available is the best thing you can do to reduce digital divide, improve possibilites for education and its good for VCs! [John Doerr - JD]
- There will be a web 2.0 "shakeout" in the next 12 months and the "shakeout" won't include mobile. "Shakeout" here means reduced, down rounds of investment. [Tony Perkins - TP]
- Moore's law will bifurcate to the point where technological advances in memory will precede logic by several years. [Don't remember who said this. Could've been Steve Jurvetson - SJ]
- Power shift: Shift in economic power to the BRIC nations will profoundly impact current business. [Joe Schoendorf - JS]
- Active Media: Consumers are choosing active media over passive media which will erode power of today's media companies and will require a re-engineering of the advertising business. [Roger McNamee - RM]
- Enterprise Web 2.0: Web2.0 functionality will move to enterprise and media in a big way. [TP]
- The next two years will herald first synthetic life form. [SJ]
- The Brain: Rise of radical approaches to treating brain disease. [JS]
- Going green could be the largest economic opportunity and imperative of the 21st century. [JD, of course!]
Fundamental Indexing
On a trial basis, I've been trying to roll some of my non-retirement savings out of mutual funds and into ETFs. Let's say I've been taking whatever I'm reading in my finance books a tad too seriously! All skepticism aside, I don't like having to shell out the expense ratio, especially when you read that many mutual funds don't even beat market returns. See excerpt from Investopedia:
With low expense ratios, ETFs are an attractive choice. But which ETF? Armed with new found knowledge about fundamental indexing (from Chapter 4 of BMA as well as Prof Percival's lecture), I did a bit of poking around.
In a capitalization weighted index, the weight associated with a particular stock is based on its market cap. In a fundamental index, that weight is based on some fundamental metric. Dividends appear to be a particularly good metric if you believe companies need to stop screwing around holding large amounts of cash, with no good projects to invest in.
See Prof Seigel's article on WSJ for a detailed description of the fundamental weighted indexes as the "next wave of investing".
The Fama/French world emphasizes low P-E and small cap stocks. Bogle et al in another WSJ article cite a few reasons about why you probably shouldn't be too eager to jump on the fundamental indexing bandwagon. They cite
The Journal of Finance (Mar 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that "by 1993 fully one-third of all mutual funds had disappeared." Furthermore, in 1997 the Wall Street Journal reported that during 1982-1992 mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period. In other words, when we take survivorship bias into account, the average mutual fund underperforms the market.All that said, I probably will stick with funds like MINDX and MAPTX when it comes to investing in foreign/emerging markets.
With low expense ratios, ETFs are an attractive choice. But which ETF? Armed with new found knowledge about fundamental indexing (from Chapter 4 of BMA as well as Prof Percival's lecture), I did a bit of poking around.
In a capitalization weighted index, the weight associated with a particular stock is based on its market cap. In a fundamental index, that weight is based on some fundamental metric. Dividends appear to be a particularly good metric if you believe companies need to stop screwing around holding large amounts of cash, with no good projects to invest in.
See Prof Seigel's article on WSJ for a detailed description of the fundamental weighted indexes as the "next wave of investing".
The Fama/French world emphasizes low P-E and small cap stocks. Bogle et al in another WSJ article cite a few reasons about why you probably shouldn't be too eager to jump on the fundamental indexing bandwagon. They cite
- Potentially high management fees for fundamental indexed funds
- Equivalency of fundamental indexing to picking low P-E and small cap stocks (which Fama/French have shown produces outsized returns)
- Turnover - say when a manager increases dividends, you're going to have to buy more of that stock. This is not an issue especially if you are investing your retirement savings.
- Fundamental indexes constructed out of dividends as the metric may not be tax efficient. (Long-term capital appreciation enjoys favorable taxation compared to short-term gains such as dividends.)
Monday, February 19, 2007
The Economics Lives of The Poor - A Summary
I'm one of those who has been excited about the possibilities offered by bottom-of-the-pyramid business models, that is, for-profit businesses that effectively and efficiently engage the underprivileged while serving unmet needs. I recommend Prof Prahlad's "Future at the Bottom of the Pyramid," if you want to look at several successful examples ranging from Casas Bahia and Cemex in Latin America to the Jaipur Foot and Aravind Eyecare in India.
A few months back, a friend pointed me to "The Economic Lives of the Poor," a working paper from the Poverty Action Lab, associated with the MIT Department of Economics. If you grew up in the developing world, you may find the data in the paper corroborating many of your observations and experiences. Nonetheless there are a few insights... (I've tried to higlight them by italicizing).
It's a 20-page paper, one I had put off reading it for quite sometime now and there's plenty of data in there. Here's a quick summary:
Data surveyed in the paper has been collected from India, Pakistan, Nigeria, Kenya, Indonesia, South Africa, Peru, Guatemala etc.
The paper defines the poor as those whose daily budget is $2.16 in purchasing power parity. The extremely poor are looking at a daily budget of $1.08. The authors use consumption rather than income because they have more accurate data on consumption.
Living arrangements
There are more people per household among poor families. The paper points out that this helps in spreading fixed costs over a larger number of people. There are many more people of prime working age (21-50) in these households than those above 50. About 0.3 is the ratio between number of old people to those of prime working age. Compare that to 0.6 in the US. High fertility and high mortality rates among older people are possible reasons. It's also possible that older people are underrepresented because they tend to be richer.
[No major surprises here.]
Spending Habits
Conventional wisdom has been that the poor don't have enough money to eat. Yet the average poor person does not spend every penny per dollar on gaining calories. Alcohol and tobacco (4%-8%), entertainment and relegious festivals (10%) occupy a prominent portion of every dollar consumed. Just eliminating alcohol and tobacco could give them 30% more to spend on food!
[I have to say not much of this is surprising to me. The poor may have more constraints to work with but they are humans too, and not necessarily more rational.]
What's somewhat interesting here is out of the money spent on food, a good chunk is spent on food that is not calorie efficient (rice, wheat, sugar as opposed to millets such as bajra or jowar) or even healthy. Based on the data from India, it appears that the trend is to spend lesser on food - 70% in 1983 to 62% in 1999.
Assets
Interesting paradox here. Among the poor land ownership is prominent: 4% in Mexico own land, 30% in Pakistan and 99% in Udaipur, India! Otherwise, the poor own very few durable assets. Quite a few people seem to own radios and about 1/2 of them own a clock or a watch.
[To me this is an interesting paradox. Is it true that the poor own land which they can't monetize?]
Health
Based on data from India, the poor consume 1400 calories per day and they have a BMI (body mass index) of 17.8. Compare that to a BMI of 18.5 which is the cut-off being underweight. Despite widespread occurence of disease, anemia, diarrhea, poor vision etc, level of self-reported happiness is not particularly low. Main causes for stress appear to be health related issues, including death.
[Wealth/happiness and poverty/sadness don't go hand in hand. I knew that!]
Based on a survey in New Delhi, India, it appears that there is good access to health care providers. What is of grave concern is the poor quality of health care, mainly due to unqualified healthcare workers. The paper talks about a survey which highlights that treatments from such unqualified healthcare providers are slightly more likely to cause more harm than good.
Education
Most kids go to school but the quality of education they get in free/public schools is quite abysmal.
How they earn money
Most are entrepreneurs - i.e they raise small amounts of capital, carry out investment and claim earnings. Because of limited skills, its easier for them to run their own business than take up a job.
Many hold multiple "jobs" and there is a notable lack of specialization. It appears they may be spreading risk by staying diversified. They also can't raise sufficient capital to create a business that would occupy all their time. The paper gives the example of women in the Indian town of Guntur. They run eateries where they cook dosas in the morning, they then move on to do other things like collect trash, manual labor etc. The businesses are also not very efficient - for instance there is a lot of waiting time in dosa making.
[Is it really diversification? Sorry to sound harsh but it does sound simplistic logic, coming from the academia! What if customers don't want dosas all day? What if they simply want more money and can't make much just on making dosas? It could get sunny in Guntur... how can they stand in the sun all day making dosas?]
There is a lot of temporary migration (less than 1 month) for work, but the paper cites the need to stay close to a social network as a reason for them to not migrate too far away or for a longer period of time.
Debt and Savings
Debt levels vary from 11% (East Timor) to 93% (Pakistan). However, they get credit mostly from informal sources, not banks or other formal lending institutions. They end up paying almost 4% per month in interest. This premium is NOT due to default rate, rather its due to the high cost of capital for the informal lending sources which gets passed to the poor consumer and also due to the perceived cost of enforcement.
No formal savings. There's a great deal of temptation to spend, especially because some of their wants are things many of us take for granted. Saving money at home is not easy: there's a danger of theft or a family member (spouse or son) stealing or taking the money away.
[No surprises.]
They respond well to micro-credit because it gives them a way to buy something and then pay it off in a disciplined manner. Checkout my friend Renuka's article in the Hindustan Times on micro-credit and women.
A few months back, a friend pointed me to "The Economic Lives of the Poor," a working paper from the Poverty Action Lab, associated with the MIT Department of Economics. If you grew up in the developing world, you may find the data in the paper corroborating many of your observations and experiences. Nonetheless there are a few insights... (I've tried to higlight them by italicizing).
It's a 20-page paper, one I had put off reading it for quite sometime now and there's plenty of data in there. Here's a quick summary:
Data surveyed in the paper has been collected from India, Pakistan, Nigeria, Kenya, Indonesia, South Africa, Peru, Guatemala etc.
The paper defines the poor as those whose daily budget is $2.16 in purchasing power parity. The extremely poor are looking at a daily budget of $1.08. The authors use consumption rather than income because they have more accurate data on consumption.
Living arrangements
There are more people per household among poor families. The paper points out that this helps in spreading fixed costs over a larger number of people. There are many more people of prime working age (21-50) in these households than those above 50. About 0.3 is the ratio between number of old people to those of prime working age. Compare that to 0.6 in the US. High fertility and high mortality rates among older people are possible reasons. It's also possible that older people are underrepresented because they tend to be richer.
[No major surprises here.]
Spending Habits
Conventional wisdom has been that the poor don't have enough money to eat. Yet the average poor person does not spend every penny per dollar on gaining calories. Alcohol and tobacco (4%-8%), entertainment and relegious festivals (10%) occupy a prominent portion of every dollar consumed. Just eliminating alcohol and tobacco could give them 30% more to spend on food!
[I have to say not much of this is surprising to me. The poor may have more constraints to work with but they are humans too, and not necessarily more rational.]
What's somewhat interesting here is out of the money spent on food, a good chunk is spent on food that is not calorie efficient (rice, wheat, sugar as opposed to millets such as bajra or jowar) or even healthy. Based on the data from India, it appears that the trend is to spend lesser on food - 70% in 1983 to 62% in 1999.
Assets
Interesting paradox here. Among the poor land ownership is prominent: 4% in Mexico own land, 30% in Pakistan and 99% in Udaipur, India! Otherwise, the poor own very few durable assets. Quite a few people seem to own radios and about 1/2 of them own a clock or a watch.
[To me this is an interesting paradox. Is it true that the poor own land which they can't monetize?]
Health
Based on data from India, the poor consume 1400 calories per day and they have a BMI (body mass index) of 17.8. Compare that to a BMI of 18.5 which is the cut-off being underweight. Despite widespread occurence of disease, anemia, diarrhea, poor vision etc, level of self-reported happiness is not particularly low. Main causes for stress appear to be health related issues, including death.
[Wealth/happiness and poverty/sadness don't go hand in hand. I knew that!]
Based on a survey in New Delhi, India, it appears that there is good access to health care providers. What is of grave concern is the poor quality of health care, mainly due to unqualified healthcare workers. The paper talks about a survey which highlights that treatments from such unqualified healthcare providers are slightly more likely to cause more harm than good.
Education
Most kids go to school but the quality of education they get in free/public schools is quite abysmal.
How they earn money
Most are entrepreneurs - i.e they raise small amounts of capital, carry out investment and claim earnings. Because of limited skills, its easier for them to run their own business than take up a job.
Many hold multiple "jobs" and there is a notable lack of specialization. It appears they may be spreading risk by staying diversified. They also can't raise sufficient capital to create a business that would occupy all their time. The paper gives the example of women in the Indian town of Guntur. They run eateries where they cook dosas in the morning, they then move on to do other things like collect trash, manual labor etc. The businesses are also not very efficient - for instance there is a lot of waiting time in dosa making.
[Is it really diversification? Sorry to sound harsh but it does sound simplistic logic, coming from the academia! What if customers don't want dosas all day? What if they simply want more money and can't make much just on making dosas? It could get sunny in Guntur... how can they stand in the sun all day making dosas?]
There is a lot of temporary migration (less than 1 month) for work, but the paper cites the need to stay close to a social network as a reason for them to not migrate too far away or for a longer period of time.
Debt and Savings
Debt levels vary from 11% (East Timor) to 93% (Pakistan). However, they get credit mostly from informal sources, not banks or other formal lending institutions. They end up paying almost 4% per month in interest. This premium is NOT due to default rate, rather its due to the high cost of capital for the informal lending sources which gets passed to the poor consumer and also due to the perceived cost of enforcement.
No formal savings. There's a great deal of temptation to spend, especially because some of their wants are things many of us take for granted. Saving money at home is not easy: there's a danger of theft or a family member (spouse or son) stealing or taking the money away.
[No surprises.]
They respond well to micro-credit because it gives them a way to buy something and then pay it off in a disciplined manner. Checkout my friend Renuka's article in the Hindustan Times on micro-credit and women.
Wednesday, January 31, 2007
Men in Thongs and Beer (and Superbowl Ads)
UPDATE from class: Thanks to Azar for the pointer to the incredibly funny iPhone ad spoof: http://www.youtube.com/watch?v=1xXNoB3t8vM . And thanks to Prof Bell for two decades of Superbowl ads.
Rolling Rock (beer) tries to leave an impression by making the ad provocative and scandalous.
If you thought you had seen it all in class with the $400 Gucci "man purse," try this: The Rolling Rock "Man in Thongs" ad. A less graphic version of this ad where the VP Marketing pretends to be apologizing, is actually live on TV. You can see his blog here.
Another ad that features the beer ape and the ad with him apologizing...
I dug up the intented takeaway of a related ad plan for the same product here. Bob Lachky, EVP Global Industry Development at Anheuser-Busch, sez:
Get Serious
While we're on the topic of adverts and promotions, checkout Serious to get a glimpse of what form your junk mail is going to take in the future! I think its a pretty neat idea.
Rolling Rock (beer) tries to leave an impression by making the ad provocative and scandalous.
If you thought you had seen it all in class with the $400 Gucci "man purse," try this: The Rolling Rock "Man in Thongs" ad. A less graphic version of this ad where the VP Marketing pretends to be apologizing, is actually live on TV. You can see his blog here.
Another ad that features the beer ape and the ad with him apologizing...
I dug up the intented takeaway of a related ad plan for the same product here. Bob Lachky, EVP Global Industry Development at Anheuser-Busch, sez:
I also think the cross-platform advertising approach that we are using on Rolling Rock is a great example. It’s kind of like the wardrobe malfunction model. You let people know about it one way, you show it to them like it’s the forbidden fruit. We’re going to run some TV spots (this week) featuring the next faux pas of the Rolling Rock marketing director. He’s going to be like we’re making a mistake, Oh, my gosh, we’re going to put this in on the Super Bowl and it features men in thongs. Research told us this was gong to be great because after all men in Europe wear thongs. Obviously it doesn’t run on the Super Bowl but the day after Super Bowl your guy comes back on TV and says I thought I made the right call but obviously I didn’t. The people in the know have obviously gone to the Web site to see the forbidden Internet piece. It’s a fun way of using TV as a tease and the payoff to the consumer is actually being delivered through the Internet. When you have a limited budget and you’ve got a portfolio our size we had better embrace new media because it is more efficient and it is more in line with the target audience than traditional media is. Not every brand can be a TV brand nor should every brand be a TV brand. In many cases it’s probably not right for the evolution of the brand.
Get Serious
While we're on the topic of adverts and promotions, checkout Serious to get a glimpse of what form your junk mail is going to take in the future! I think its a pretty neat idea.
Sunday, January 28, 2007
Crash the Superbowl
When I recently read about Yahoo's acquisition of Jumpcut, I was starting to wonder exactly how these companies are going to make money.
Turns out Jumpcut is used as an enabler in the viral marketing/user-generated ad contest Doritos. It seems to have the effect of a viral buzz effect in online social networks while simultaneously getting some high quality ads for Doritos.
If you haven't already, take a look at the ads in Crash the Superbowl. What I couldn't help notice is that 3 out of the 5 ads seem to be using some type of accident for humor.
While we're on the topic of user created ad contests, check out some submissions for the Dove's user created ad contest (which was open only to women), supposed to air on Feb 25 during an Oscar commercial break.
If you are from my Wharton class, you may find this description of the JumpCut CEO at VentureBeat somewhat amusing: "He then enrolled into Stanford’s MBA program, where they teach you to start companies."
While we're thinking about monetizing social networking and user generated content, you may also find Prof Percival's comments on valuing social networking ventures quite interesting:
Turns out Jumpcut is used as an enabler in the viral marketing/user-generated ad contest Doritos. It seems to have the effect of a viral buzz effect in online social networks while simultaneously getting some high quality ads for Doritos.
If you haven't already, take a look at the ads in Crash the Superbowl. What I couldn't help notice is that 3 out of the 5 ads seem to be using some type of accident for humor.
While we're on the topic of user created ad contests, check out some submissions for the Dove's user created ad contest (which was open only to women), supposed to air on Feb 25 during an Oscar commercial break.
If you are from my Wharton class, you may find this description of the JumpCut CEO at VentureBeat somewhat amusing: "He then enrolled into Stanford’s MBA program, where they teach you to start companies."
While we're thinking about monetizing social networking and user generated content, you may also find Prof Percival's comments on valuing social networking ventures quite interesting:
If MySpace becomes the model, social networking sites will be quite different from the classic dot-com bubble companies which tried to cash in big by going public while staying independent. The risks are not the same when an iffy venture is part of something bigger, says John R. Percival, adjunct professor of finance at Wharton. "This is kind of like the oil and gas business. The risk might not be as great as you think, and a high valuation might be justified."
A small, independent oil driller faces a huge risk in drilling a new hole, which may be dry, he says. Compared to that, risks from changing oil prices and demand are relatively small. But the situation is reversed when the driller is part of a bigger enterprise that drills many wells. A dry hole here and there doesn't matter, but changes in oil prices and demand do.
Social networking sites may be risky for their founders and the venture capital firms that fund them in the early years, but they don't appear to be pumping huge amounts of risk to the marketplace the way tech firms did in the late 1990s. "If you have a little bit of money invested in this and you're already invested in other things," says Percival, "frankly the risk is not as big as you think."
Monday, January 8, 2007
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:
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:
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:
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.
Before I proceed to review the Magic Formula, the following points represent my underlying investing philosophy:
- 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.
- 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.
- I'm too lazy to keep constant track of my portfolio and I hate transaction costs. I therefore like buy-and-hold approaches.
- 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:
- Create a composite ranking of companies by ROIC and EY.
- Buy stocks for 20-30 of them (you could do it gradually)
- At the end of the year, review and:
- sell losers 1 day before before the end of the year
- sell winners 1 day after the year end
- 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.
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