[...] Jane wrote an interesting post today onHere’s a quick excerptFor example, check out this magic formula investing blog, the blog is filled with posts about the under performance of the magic formula. Although the blog is a great read, it’s unfortunate the fella is losing money. … [...]

I’m a big fan of Joel Greenblatt.
Like the ol’ Ben Graham, he wrote one story for passive investors (the magic formula concept) and one for the “enterprising” investor (the special-situations strategies in his stock-market-genius-book).
The big question is, whether there is any possibility to beat the market without having to dig through piles of financial reports. I think there are several of such “quantitative approaches”. You won’t get Buffet-like results with any one of them, but you may outperform the averages by 5 or even 10% p.a..

The most simple approaches are something like “buy the bottom Price to Earnings/ Price to Book decile of the market and sell after 1 year”. There have been numerous surveys on such stock-picking methods and their performance versus the market-average or the so called growth- or glamour-stocks (top-decile).

The bottom line is: you can make yourself an exra 3 to 5 % by sticking to these approaches.
Plus, and this is a big plus, these superior results don’t arive because these stocks bear extra risk (higher betas). In fact, they even show lower betas-factors than the glamour-portfolios.

But, and this is a big but :-), you won’t beat the market in any one year or even in any 3-year period. That’s also Greenblatts message.

Saying, Greenblatts magic formula will underperform the market is against common sense, because it is like saying:
Yes, you will outperform the market by choosing stocks with low PE/high earnings yield, but only if these companies don’t have a superior return on capital.
This is weird logic… Voodoo…. Bizarro-Land.

Yeah, last 2 and 1/2 years were bad, but people also called Warren Buffet a dinosaur and sang dirges on value-investing when Berkshire Hathaway lagged the market in the midst of the dot-com bubble.
The magic formular will win… in the long run.

By the way… nice blog !

Greetings from Germany,

Sebastian Koch

Since I do agree that over long periods of time MFI will under perform the market (it’s only natural… when people shift between growth and value… that debate can go on forever as to what exactly I mean, but it’s besides the point).

I have been testing a combination where I take the MFI, and on every saturday I plug the $1M, $500M, and $2B top 100 into Louis Navallier’s screen from his book. The main reason I do it is to see what stocks are getting a lot of institutional buying. The Get Rich With Growth screen only updates once a week, on saturdays, and so far it has been doing pretty well. At first I had tried to track it through excel, but I set up a Marketocracy portfolio as well about 2 weeks ago. Both seem to be outperforming the market.

I put up a list every week on the blog I sometimes write on, so you can either follow there or do it yourself, but it’s an interesting way of making a portfolio. It would be interesting to see if someone could backtest it though. My guess is that it would do pretty well.

First of all, thanks for taking the time to visit my blog, I appreciate it.
Sebastian,Awesome comment!
“But, and this is a big but :-), you won’t beat the market in any one year or even in any 3-year period. That’s also Greenblatts message.” Investors (particular those on Wall St) are so intrigued and pressured by short term performance that they forget its a tough thing to do. Bill Miller in a recent interview/shareholder letter? said something in the lines of “In a perfect world, we would love to outperform the market every month,quarter,year, but it is almost impossible”
its no secret that low valuation metrics such as low P/E , P/BV,etc outperform the market. So why do investors fail? They will not stick with the program!! People want excitement, people want to be active.Value investing does not offer that.

Alex, do you have a link to those marketocracy portfolios?

can we exchange links ??

http://www.madmoneyfund.blogspot.com/

Alex,

I linked to your Magic Formula article from Magic Formula Investing. Where I am proud to say that we are beating, just barely beating, the market.

Have a great weekend and keep up the good work on your blog.

-Nick

Hmmn I botched the link:

http://www.magic-formula-investing.blogspot.com

The book does not explain how to hanlde the profits, i.e. if I buy 5 stocks, 1K each every 2 months 5 times, I will have invested a total of 25K. A year after the first purchase, say I made a 1K profit on the first batch, then I take a loss of 1K on the second batch, then 2K profits on the third batch and on and on until I have closed the cycle.

While the first year, I have clean 5K accounts every 2 months, the second year, each account becomes different in size so the question I am asking is:

Does one need to take the profits out and keep them out of the MFI system and always work with a base of 5K or does one needs to reinvest all dividends and profits without ever taking anything out?

The reason I ask is because I did re-invest everything everytime and now not only do I have amounts that are different from one cycle to the next but while my initial (first year capital) did apreciate 30% in 2006, I have now lost all of my unrealized profits and now stand with 10% loss on the initial capital.

Anyone can help clarifiy this?

Greenblatt does not specify what to do with earnings or losses….hmmm why not make the amount you put in automatic, i.e put 5% of capital (random #) into a stock regardless whether you are up or down? I guess Joel Greenblatt leaves it up to you.

Nick: congrats on beating the market , keep us updated

What I am most curious about is how do people who use the http://www.magicformulainvesting.com site choose the stocks from the generated list that they invest in?

According to the book, the part of the formula that tells you which stocks from the site generated list to pick are the top-ranked stocks. The caveat here is the site DOES NOT produce the list in a top-ranked order. Its alphabetical. So it is up to the you to put the list into top ranked order and then pick the first five to seven stocks from that reordered list.

Top ranked order is a three-step process. The first step is to put the list in order starting with the highest return on capital. This is then ranked starting with 1. The second step is to put the list in order starting with the highest earnings yield and assign a rank starting with 1. The last step is to combine these rankings. Now sort by the combined rankings and you’ll have a list that shows the top-ranked stocks based on the combination of these two factors.

So back to my original question - how are people choosing stocks from the site generated lists? Is it by random or truly using the formula?

That post is coming johnny it will have your answer

Johnny, many people are picking randomly from the lists. Many people seem to think that being number 1 on the list is not that different from being number 25 on the list. In terms of earnings yield and return on capital (the two MFI metrics), all 25 stocks on the top list are absolutely creme de la creme. If earnings yield and return on capital were the only factors that make a stock perform or fail, then being able to rank against each other, as you wish to do, the top 25, would be more important. In reality, the much more critical task is to be able to find and exclude the dogs in the top 25, or top 50, not the rank of the top 25 or 50. Even if you find out the top 5 or 6 stocks of the top 25, those 5 top stocks (top in terms of the two MFI metrics) can be dogs that you should not buy. Sometimes a stock has wonderful MFI metrics (earnings yield and return on capital) for very temporary reasons, and is therefore a poor investment. All Greenblatt says is that over the long term, even with buying dogs on the list, MFI will do well.

The more important thing to do is not to internally rank the top 25, since in MFI terms they are all super high already. The more important task is to find out which of the top 25 are dogs. If one could exclude the dogs, one should get an even higher return than predicted by Greenblatt from a random selection from the lists. For excluding the dogs, people have all kinds of methods. http://www.magicdiligence.com has articles where the author analyzes MFI stocks to weed out dogs. He charges an annual fee if you want to know his list of buys and sells, but one can read many of his articles for free.

Another way to try to weed out dogs from the MFI list is to pump an MFI list into other stock rating systems out there on the internet for free, and then only pick the MFI stocks that get the best ratings from the other stock rating systems. Of course if you try this method, it might be best to create some virtual portfolios before you actually buy, and watch what results you would get if you used a second screen to select stocks from the MFI lists. But one would have to watch for a while to determine if the results are meaningful. Navellier, for example, has a free stock rating system on the internet, but there is some anecdotal evidence out there that the Navellier system is not a good second screen for MFI.

In any case, if you want to internally rank the top 25 MFI stocks in terms of the MFI metrics, Marshall Gerda at a yahoo magic formula investing group has created a spreadsheet that automatically calculates the earnings yield and the return on invested capital of a stock, and very closely succeeds in mimicking Greenblatt´s calculation methods, so that one can rank the top 25 or top 50, exactly as you expressed a wish to do. However that Marshall Gerda spreadsheet calculates the MFI metrics for only one stock at a time, and takes perhaps thirty seconds or a minute to do so. You have to input each stock ticker each time, then click “yes” twice during the calculation process for that stock, so it´s not a super fast way to get the calculations for 25 stocks, and even once you do have the ey and roic for each stock, you still have to rank them yourself, which means messing with excel for few minutes.

I just graduated college with a degree not related to finances or anything of that sort. My father trades and is very successful. I tried day trading and I did good at the end of 2007. But now in 2008, I am back with the same amount of money I started out with…2.5K I just put my money in the market using Greenblat’s formula. I hope that the down market will come up and then the % return for the stocks I chose to be outstanding. The hard part is trying to figure out when the market will bounce back. I have a feeling it will be when Congress allows offshore and onshore drilling. That may take a while with the dems….

dak: “The hard part is trying to figure out when the market will bounce back.”

No one knows what or when the market will bounce back. All we can do is buy great businesses that are on sale. Good luck with the Magic Formula!

I’m a big fan of the MFI method, but to me it’s a great SCREENING tool; just buying off the list seems crazy to me. What I do is get ideas from a wide range of sources (including the MFI website), and run them all through my own MFI spreadsheet. Then I apply my own views; for example I’d rather buy a company with good MFI numbers and solid growth, than a company with great MFI numbers and no growth. I particularly look for stocks with growth in the 8% to 12% range, which is low enough that the market doesn’t get excited, but high enough that the returns add up over the years. Here’s a concrete data point, albeit with a tiny data set: in December 2005 I tucked away a list of 32 stocks (only 5 from the MFI website) that I’d evaluated. When I came back a year later, the top half (by MFI ranking) had gained 17% in the year, and the bottom half had gained 4%). The 5 from the MFI website had gained 7.5%. I do agree that I haven’t had great luck with stocks from the MFI website (though I don’t hold them for the designated period, so I’m a bad test).