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This follows closely Graham's philosophy of value investing. Do your own work Don't trust anyone over 30 Don't trust anyone 30 or under As an educator and a strong advocate of learning, Greenblatt believes in being open-minded to new ideas.
He points out that Buffett's success is due to his unique spin on Graham's thinking and philosophy. The idea of the magic formula is to provide A long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.
If I plug my estimates into the Magic Formula, and it comes out cheap, that's good. Joel Greenblatt's magic formula was previously tested on old school value with a heavy dose of skepticism, but numbers don't lie. See for yourself. The original magic formula numbers first. I create a close variant to the original Magic Formula to compare it side by side along with the market. There's been a lot of discussion about whether the magic formula has lost its touch.
Is it too popular? Is it overcrowded? The argument is that the book is a best seller so more people know about it, and it has become a crowded strategy now. But consider this: value investing is not popular to begin with because it requires hard work to do it properly and the magic formula is a subset of value investing This leads me to believe that there is plenty of room before it ever gets crowded. The closest I've come to is creating a custom Quality, Value and Growth strategy, but that too isn't guaranteed.
The most important thing is for investors to believe in their system even if it's not working in the short term. As of today, Gotham funds have been underperforming the market for a couple of years, but it's still too early to claim whether a system is working or not. Especially when the system has been proven before and backtested evidence shows that it works.
Greenblatt believes that consistency is key to his fund's success and if you look at the quotes section below, you'll notice his emphasis on sticking with the long term and not getting pushed out of a strategy due to short term underperformance. He is likely the one that really brought special situations to value investors. Sure Buffett wrote about workouts in his letters before Greenblatt even got started, but when it comes to teaching about special situations, Greenblatt is the best.
In fact, you can download and read notes to Greenblatt's Columbia Business School special situation class from a decade ago. Also, here's another good link that provides notes to a lecture from Greenblatt's value investing class video going over some of his previous stocks. When selling stocks, Joel Greenblatt takes the same objective and simple approach.
I usually try to sell before my investment reaches a conservative estimate of fair value. In other words, I usually sell too early. In addition, I may sell before an investment reaches even that discount to conservative fair value if I find something else a lot cheaper and it makes sense to make the exchange after looking at my overall portfolio. This quote ties in very much with the magic formula where stocks are sold after one year.
Joel Greenblatt Famous Quotes Here is part of the tradeoff with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term. Many studies over the years have confirmed that value-oriented strategies beat the market over longer time horizons. Several different measures of value have been shown to work. These strategies include, but are not limited to, selecting stocks based upon low ratios of price to book value, price to earnings, price to cashflow, price to dividends… these simple value strategies do not always work.
The second ratio focuses on the earnings relative to tangible assets. Many assets listed on the balance sheet depreciate over time as their usefulness is used up. These types of assets are called "fixed assets. This gives a more accurate sense of the real value of a company's assets, compared to just looking at the total asset number on the balance sheet.
Working capital is also part of this ratio and is current assets minus current liabilities. This gives a picture of whether the company is likely able to continue operations in the short term. While the two ratios in the magic formula look small, they actually are computing a lot of data about the inner workings of a company, including: Earnings.
If over the 20 year period from to you bought the 10 best Magic Formula companies each year you would have outperformed the market by 7. Better risk adjusted return Not only did you outperform the market, the higher returns you generated would have more than compensated you for the higher volatility of the Magic Formula portfolio which only had 10 investments compared to the market portfolio which had more than companies.
As you can see the table below the Magic Formula portfolio had a substantially higher risk adjusted return or Sharpe Ratio higher is better which means you were very well compensated for the higher ups and downs volatility of the Magic Formula strategy. Just how much better did the Magic Formula perform? How much better would you have done if you used the Magic Formula?
The following chart shows this very clearly. Magic Formula gave you This is Market portfolio only gave you 2. Magic formula investing refers to a rules-based, disciplined investing strategy that teaches people a relatively simple and easy-to-understand method for value investing. Put simply, it works by ranking stocks based on their price and returns on capital.
Magic formula investing tells you how to approach value investing from a methodical and unemotional perspective. Developed by Joel Greenblatt—an investor, hedge fund manager, and business professor—the formula applies to large-cap stocks but doesn't include any small or micro-cap companies. Key Takeaways Magic formula investing is a successfully back-tested strategy that can increase your chances of outperforming the market. The strategy focuses on screening for companies that fit specific criteria and uses a methodical, unemotional process to manage the portfolio over time.
The strategy, which is value-based, was developed by investor and hedge fund manager Joel Greenblatt and published in The Little Book That Beat the Market in The magic formula excludes certain types of companies, such as those with a small market capitalization, foreign companies, finance companies, and utilities.
Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania. He is an adjunct professor at Columbia University's business school. In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital. Instead of conducting fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 20 to 30 top-ranked companies in which to invest.
Company rankings are based on: Their stock's earnings which are calculated as earnings before interest and taxes EBIT. Their yield, calculated as earnings per share EPS divided by the current stock price. Their return on capital measures how efficiently they generate earnings from their assets. Investors who use the strategy sell the losing stocks before they have held them for one year to take advantage of the income tax provision that allows investors to use losses to offset their gains.
They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains. Then they start the process all over again. Magic formula investing only factors in large cap stocks and doesn't include small cap companies. The remainder will all be large companies but excludes financial companies , utility companies , and non-U. The following points outline how the formula works: Set a minimum market capitalization for your portfolio companies.
Ensure you exclude any financial or utility stocks when you choose your companies. These are stocks in foreign companies. Rank selected companies by highest earnings yields and highest return on capital. Buy two to three positions each month in the top 20 to 30 companies, over the course of a year.
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