Dealing with the ups and downs of Joel Greenblatt’s Magic Formula

Friday, Jul 14 2017 by
17
Dealing with the ups and downs of Joel Greenblattrsquos Magic Formula

One of the arduous challenges faced by investors is dealing with periods of underperformance. Different investing styles tend to suit different market conditions. So it doesn’t matter what the strategy is, there’ll always be times when it just doesn’t work. For those with a preference for a certain style, the discipline is in staying the course and sticking with the rules.

Few will know this better than followers of Joel Greenblatt’s Magic Formula. Greenblatt, an American fund manager, is behind a strategy that uses a simple combination of value and quality in its search for winners. It looks for good businesses at bargain prices, which Greenblatt claims “is the secret to making lots of money” (in his book, The Little Book that Beats the Market).

The trouble is that even cheaply priced, good stocks don’t always perform well as a whole in the stock market. For instance, investors in US markets have found in recent years that very expensive growth stocks can stay popular for a surprisingly long time. In these phases, nobody wants to buy value stocks, no matter how good are. And even when value does come into fashion there are times when individual shares simply implode. And that's exactly what we saw this week...

How the tide turned for the Magic Formula

Last December I wrote about the fact that Stockopedia’s tracking of a screen inspired by the Magic Formula was on a bit of a roll. It’s gone on to rocket during the past six months. Joel Greenblatt said that despite the down years the strategy would outperform - and it seems to be doing just that. Except...

5968eddb763e9Greenblatt.png

Take a look at that chart and it’s quite clear that an impressive run over the past year has ground to a halt. To be fair, equities have drifted during June and July, so some slowdown might be expected. But the last week has been terrible, and there’s a good (well bad, really) reason for that - Carillion.

Carillion just missed out on being brought into the Magic Formula folio at the end of March, but made the grade for the June rebalancing two weeks ago. Unfortunately, Carillion’s massive profit warning this week means the portfolio is sitting on a 70% loss on that position.

Now, hypothetically speaking, if the Guru Strategies applied…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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Carillion plc is an integrated support services company. The Company operates through four business segments: Support services, Public Private Partnership projects, Middle East construction services and Construction services (excluding the Middle East). The Support Services segment includes its facilities management, facilities services, energy services, rail services, road maintenance services, utilities services, remote site accommodation services and consultancy businesses in the United Kingdom, Canada and the Middle East. The Public Private Partnership projects segment invests in Public Private Partnership projects in the United Kingdom and Canada. The Middle East construction services segment includes its building and civil engineering activities in the Middle East and North Africa. The Construction services segment includes its the United Kingdom building, civil engineering and developments businesses, together with those of its construction activities in Canada. more »

LSE Price
18.5p
Change
-3.9%
Mkt Cap (£m)
79.6
P/E (fwd)
0.9
Yield (fwd)
n/a



  Is Carillion fundamentally strong or weak? Find out More »


2 Comments on this Article show/hide all

iwright7 16th Jul 1 of 2

Ben - Succinct article, well written.

Greenblat's published approach has Q and V elements which can pick out good cheap companies with a hidden moat. But it doesn’t go far enough to produce outstanding results. In my IMHO the Magic Formula needs a min Altman score and +ve RS/Momentum rules to screen out the dross. 

I have thoughts  on what the additional screening metrics should be incorparated to improve Magic Formula "Esqe" consistency, but on a lazy Wimbledon Sunday are there others out there with views?  Ian

Current MF Stocko Rules:

Mkt Cap £m > 30

Magic Formula Rank > 0

Rank ( Earnings Yield % ) < 99%

Rank ( ROC % Greenblatt ) < 99%

Sort by  Magic Formula Score (for Top 25)

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Mark Carter 16th Jul 2 of 2
3

My own fantasy fund based on the Greenblatt screen shows a remarkable up hill and down dale performance over the last 3 months, and it doesn't even own Carillion (LON:CLLN). There's a lot of systematic behaviour in the market, where strategies wax and wane.

In the year to June 2016 the Greenblatt screen showed a mediocre performance at best, but then when on to shoot the lights out. I have noticed this with a few other screens. Provided a strategy is sound, getting into a strategy that has performed poorly over the preceeding year looks to be a good bet generally.

It's also worth pointing out the Q and V scores published by Stockopedia can also be used to confirm the Greenblatt screen.

But here's the question: is it  high Q + high V  that is likely to lead to superior performance, or is it low Q + high V that is better? Work by Tobias Carlisle suggests leads me to suspect that it is the latter, rather than the former, that is likely to be the outperformer.

Why might that be? Well, the problem is with cyclical companies. They tend to look cheap, and look the best quality near cyclical tops, and look expensive and poor quality at cyclical lows (which is the best time to invest). In other words ... investing is hard.

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About Ben Hobson

Ben Hobson

Strategies Editor at Stockopedia. My goal is to help private investors learn and invest with confidence through the articles, ebooks and other resources we publish on site. I also occasionally bunk off to interview famous investors at expensive restaurants. I studied History at Aberystwyth University, trained as a journalist and covered business news and corporate finance before settling in as one of the first staff members at Stockopedia.  Away from Stockopedia I'm a mountain bike junkie. more »

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