Investorial

Sometimes it’s hard to get a true value investor to not talk about the facts and come with some emotion, just ask Jim Chuong! Does this mean that value investing fund managers don’t ever hard sell? There are always exceptions and Joel Greenblatt of Magic Formula Investing is one of them.

Though the site sounds more like it belongs to Ripley’s Believe It or Not, Joel considers himself a value investor and is the author of the book, The Little Book That Beats The Market (you can read excerpts on Amazon.com). I recently read an April 2006 interview that Joel did with MoneySense. The interview angle depicted Joel as if he was a sideshow salesman who’s found the magic formula to generate great investment returns. Joel talks candidly about his book and the website. After reading the interview and checking out the website, here’s what I thought about the whole deal.

The Good
Following a good formula to invest helps take care of the emotion factor. True to form, Joel focuses more on the psychologies behind buying the stock, rather than selling the stock. Magic Formula Investing is also a very simple to use stock screener — a good starting point for investors looking for ideas. But I hope most people will do their own research thoroughly before going by those screening results!

The Bad
The magic formula may be too simplistic. It filters out companies by applying stock screens that look for “good” and “cheap”. Those two qualities were described by Joel as:

We define “good” as a company that earns a high return on capital and we define “cheap” as a company that earns a lot compared to the price we’re paying for it.

These stock screen should actually leave a lot of companies in the running. Joel talks heavily about Price Earnings (P/E) ratio; a metric that value investors don’t highly regard. It is more reminiscient of what a growth manager would screen for, as they are looking for companies with earnings growth potential. Joel later clarifies that he looks at a company’s pre-taxed earnings.

Besides P/E, Joel also seeks out companies with a high Return-on-Capital (ROC). But ROC does not look at a company’s debt picture. Instead Joel refes back to everybody’s favourite number, the P/E ratio.

We don’t use a simple earnings yield on the Magic Formula site, we use a pre-tax earnings yield, which takes into account the debt that the underlying company has. We adjust for differences in debt and differences in tax rates when we figure out the earnings yield, so we implicitly take care of that. In other words, if a company has an extremely high debt level, it won’t appear near the top of our list unless it’s making an awful lot of money to make up for that.

Relying on earnings is a catch-22. On one hand, you want to know if a company is earning money, on the other hand it is heavily subjected to the whims of the financial officer. Just ask Kenneth Lay and Enron! It is the metric that most investors in the market key on, and that manic following in a self-destructing cycle since executives are now pressured to deliver or cook “favourable” results.

I also worry when interviews start talking about historical performance like its irrefutable fact. Joel talks extensively about how the formula works when applied to historical data. Hindsight is 20/20 and it is never the same when you are faced with the current buying decision vs. the history books telling you that it came the way you wanted it. There is no indication that Joel has “skin in the game”; that he puts his money where his mouth is and invests the same way as he preaches. I’m not suggesting that he doesn’t, but thowing it out as a caveat that many fund managers find it easier to quote studies and models, than eat their own cooking.

The Ugly
Writing the interview as “The Magic Money Machine: Triple Your Investing Returns” is horrendously misleading, and I’ll pin that blame on the interviewer Duncan Hood. To suggest that anyone can get high returns by following a formula is dangerous. Here’s the catch! There might be nothing wrong with the formula, because it’s uncontrollable how an individual uses it. As well, if everybody is doing formulaic value investing, then value investors will soon see diminished returns from everybody going after those cheap unloved companies. That’s why I count my blessings everyday for traders, growth investors, swing investors and all those with other styles!

Perhaps the ugliest thing I saw was finding out how the formula was applied. Here’s a quote from Joel Greenblatt:

You just buy five to seven stocks recommended by the site every few months and turn them over after holding on to them for a year. We tried to make it easy.

Making it easy is not the same as making it better. Fastfoods are easy, but are they good for us? Not exercising is easy, but also lazy! “Easy” is one of those must-use words uttered by marketers to entice the average Joe. To buy five to seven stocks and turn it over shortly after a year is definitely not the actions of true value investors that I know. This statement is putting a loaded gun in the hands of the average investor and telling them it’s “easy” to pull the trigger.

Buying A Counterfeit Dollar
Investing by formula is not necessary value investing. When you only compare 2 numbers (ROC and P/E ratio), it isn’t enough to justify the decision that this company is a bargain. Value investors look for bargains as a means to protect their investment and search high and low to determine an “intrinsic value”. In their quest, they will examine many other numbers that gives a better indication of the company’s health such as debt ratio, cashflow ratio, return on equity and many more metrics. Value investors seek to buy a dollar for 50 cents, but they also take more time to find out whether the dollar is counterfeit.

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