Sign up today for an exclusive discount along with our 30-day GUARANTEE — Love us or leave, with your money back! Click here to become a part of our growing community and learn how to stop gambling with your investments. We will teach you to BE THE HOUSE — Not the Gambler!

Click here to see some testimonials from our members!

Joel Greenblatt – Value Investing Doesn’t Always Work, Which Is Precisely Why It Works

By The Acquirer’s Multiple. Originally published at ValueWalk.

One of the best reads for any investor is the book, Hedge Fund Market Wizards: How Winning Traders Win, by Jack Schwager. The book provides successful trading philosophies and strategies from fifteen traders who’ve consistently beaten the markets, one of which is Joel Greenblatt. In the book, Greenblatt discusses how he developed his Magic Formula and why value investing continues to work.

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Timeless Reading eBook

Also read:

My favorite Greenblatt quote from the interview is:

“If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing.”

Joel Greenblatt

Here’s an excerpt from the book:

[How the Magic Formula was Developed]

We looked at the 2,500 largest companies in the U.S. In the first test, we ranked the stocks based on the EBIT/EV ratio. We used Compustat’s Point-in-Time database, which is the actual data that was available as of any given past date, so there is no look-ahead bias. That database starts in 1988, so we started our test from that date.

We took the same 2,500 companies and ranked them on their return on capital. We then combined the two ranking —one based on the earnings yield and the other on return on capital. Effectively, we equally weighted these two measures by adding the two rankings, which gave us the best combination of cheap and good. If a company ranked number one based on earnings yield and 250 based on return on capital, its combined rank value would be 251. We weren’t looking for the cheapest companies, and we weren’t looking for the best companies. We were looking for the best combination of cheap and good companies. In the book, I called this combined ranking the Magic Formula.

During the 23 years of our backtest, using the Magic Formula to choose a portfolio of the top 30 names from the 1,000 largest capitalization stocks would have approximately doubled the return of the S&P 500 (19.7 percent versus 9.5 percent). (Selecting portfolios from the 2,500 largest companies would have had an even larger outperformance, but would have required holding less liquid smaller cap stocks.) The decade of the 2000s was particularly interesting. During 2000 to 2009, the formula still managed to deliver an average annualized return of 13.5 percent, even though the S&P 500 was down nearly 1 percent per year during the same period.

The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value. We also divided the formula rankings into deciles with 250 stocks in each decile. Then we held those stocks for a year and looked at how each of the deciles did.

We repeated this process each month, stepping through time. Each month, we had a new set of rankings, and we assumed we held those portfolios (one for each decile) for one year. We did that for every month in the last 23 years, beginning with the first month of the Compustat Point-in-Time database. It turned out that Decile 1 beat Decile 2, 2 beat 3, 3 beat 4, and so on all the way down through Decile 10, which consisted of bad businesses that were nonetheless expensive. There was a huge spread between Decile 1 and Decile 10: Decile 1 averaged more than 15 percent a year, while Decile 10 lost an average of 0.2 percent per year.

Since there is such consistency in the relative performance between deciles, wouldn’t buying Decile 1 stocks and selling Decile 10 stocks provide an even a better return/risk strategy than simply buying Decile 1 stocks?

My students and hundreds of e-mails asked the exact same question you just did. The typical comment was, “I have a great idea, Joel. Why don’t you simply buy Decile 1 and short Decile 10? You’ll make more than 15 percent a year, and you won’t have any market risk.” There’s just one problem with this strategy: Sometime in the year 2000, your shorts would have gone up so much more than your longs that you would have lost 100 percent of your money.

This observation illustrates a very important point. If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing.

The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term. Our formula forces you to buy out-of-favor companies, stocks that no one who reads a newspaper would think of buying, and hold a portfolio consisting of these stocks that, at times, may underperform the market for as long as two or three years.

Most people can’t stick with a strategy like that. After one or two years of underperformance, and usually less, they will abandon the strategy, probably switching to a strategy that has done well in recent years. It is very difficult to follow a value approach unless you have sufficient confidence in it. In my books and in my classes, I spend a lot of time trying to get people to understand that in aggregate we are buying above-average companies at below-average prices. If that approach makes sense to you, then you will have the confidence to stick with the strategy over the long term, even when it’s not working. You will give it a chance to work. But the only way you will stick with something that is not working is by understanding what you are doing.

The post Joel Greenblatt – Value Investing Doesn’t Always Work, Which Is Precisely Why It Works appeared first on ValueWalk.

Sign up for ValueWalk’s free newsletter here.


Do you know someone who would benefit from this information? We can send your friend a strictly confidential, one-time email telling them about this information. Your privacy and your friend's privacy is your business... no spam! Click here and tell a friend!





You must be logged in to make a comment.
You can sign up for a membership or get a FREE Daily News membership or log in

Sign up today for an exclusive discount along with our 30-day GUARANTEE — Love us or leave, with your money back! Click here to become a part of our growing community and learn how to stop gambling with your investments. We will teach you to BE THE HOUSE — Not the Gambler!

Click here to see some testimonials from our members!