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    On Formulaic Investing
    Copyright © 2006, Geoff Gannon

    One question almost every investor asks at some point is whether 
    it is possible to achieve above market returns by selecting a 
    diversified group of stocks according to some formula, rather 
    than having to evaluate each stock from every angle. There 
    are obvious advantages to such a formulaic approach. For the 
    individual, the amount of time and effort spent caring for his 
    investments would be reduced, leaving more time for him to spend 
    on more enjoyable and fulfilling tasks. For the institution, 
    large sums of money could be deployed without having to rely 
    upon the investing acumen of a single talented stock picker. 
    
    Many of the proposed systems also offer the advantage of matching 
    the inflow of investable funds with investment opportunities. An 
    investor who follows no formula, and evaluates each stock from 
    every angle, may often find himself holding cash. Historically, 
    this has been a problem for some excellent stock pickers. So, 
    there are real advantages to favoring a formulaic approach to 
    investing if such an approach would yield returns similar to 
    the returns a complete stock by stock analysis would yield.
    
    Many investment writers have proposed at least one such formulaic 
    approach during their lifetime. The most promising formulaic 
    approaches have been articulated by three men: Benjamin Graham, 
    David Dreman, and Joel Greenblatt. As each of these approaches 
    appeals to logic and common sense, they are not unique to these 
    three men. But, these are the three names with which these 
    approaches are usually most closely associated; so, there is 
    little need to draw upon sources beyond theirs.
    
    Benjamin Graham wrote three books of consequence: "Security 
    Analysis", "The Intelligent Investor", and "The Interpretation 
    of Financial Statements". Within each book, he hints at various 
    workable approaches both in stocks and bonds; however, he is most 
    explicit in his best known work, "The Intelligent Investor". 
    There, Graham discusses the purchase of shares for less than two 
    - thirds of their net current asset value. The belief that this 
    method would yield above market returns is supported on both 
    empirical and logical grounds. 
    
    In fact, it currently enjoys far too much support to be 
    practicable. Public companies rarely trade below their net 
    current asset values. This is unlikely to change in the future. 
    Buyout firms, unconventional money managers, and vulture 
    investors now check such excessive bouts of public pessimism by 
    taking large or controlling stakes in troubled companies. As a 
    result, the investing public is less likely to indulge its 
    pessimism as feverishly as it once did; for, many cheap stocks 
    now have the silver lining of being takeover targets. As Graham's 
    net current asset value method is neither workable at present, 
    nor is likely to prove workable in the future, we must set it 
    aside.
    
    David Dreman is known as a contrarian investor. In his case, 
    it is an appropriate label, because of his keen interest in 
    behavioral finance. However, in most cases the line separating 
    the value investor from the contrarian investor is fuzzy at best. 
    Dreman's contrarian investing strategies are derived from three 
    measures: price to earnings, price to cash flow, and price to 
    book value. 
    
    Of these measures, the price to earnings ratio is by far the most 
    conspicuous. It is quoted nearly everywhere the share price is 
    quoted. When inverted, the price to earnings ratio becomes the 
    earnings yield. To put this another way, a stock's earnings yield 
    is "e" over "p". Dreman describes the strategy of buying stocks 
    trading at low prices relative to their earnings as the low P/E 
    approach; but, he could have just as easily called it the high 
    earnings yield approach. Whatever you call it, this approach has 
    proved effective in the past. A diversified group of low P/E 
    stocks has usually outperformed both a diversified group of high 
    P/E stocks and the market as a whole. 
    
    This fact suggests that investors have a very hard time 
    quantifying the future prospects of most public companies. While 
    they may be able to make correct qualitative comparisons between 
    businesses, they have trouble assigning a price to these 
    qualitative differences. This does not come as a surprise to 
    anyone with much knowledge of human judgment (and misjudgment). I 
    am sure there is some technical term for this deficiency, but I 
    know it only as "checklist syndrome". Within any mental model, 
    one must both describe the variables and assign weights to these 
    variables. Humans tend to have little difficulty describing the 
    variables - that is, creating the checklist. However, they rarely 
    have any clue as to the weight that ought to be given to each 
    variable. 
    
    This is why you will sometimes hear analysts say something like: 
    the factor that tipped the balance in favor of online sales this 
    holiday season was high gas prices (yes, this is an actual 
    paraphrase; but, I won't attribute it, because publicly attaching 
    such an inane argument to anyone's name is just cruel). It is 
    true that avoiding paying high prices at the pump is a possible 
    motivating factor in a shopper's decision to make online 
    Christmas purchases. However, it is an immaterial factor. It is a 
    mere pebble on the scales. This is the same kind of thinking that 
    places far too much value on a stock's future earnings growth and 
    far too little value on a stock's current earnings. 
    
    The other two contrarian methods: the low price to cash flow 
    approach and the low price to book value approach work for the 
    same reasons. They exploit the natural human tendency to see a 
    false equality in the factors, and to run down a checklist. For 
    instance, a stock that has a triple digit price to cash flow 
    ratio, but is in all other respects an extraordinary business, 
    will be judged favorably by a checklist approach. However, if 
    great weight is assigned to present cash flows relative to the 
    stock price, the stock will be judged unfavorably. 
    
    This illustrates the second strength of the three contrarian 
    methods. They heavily weight the known factors. Of course, they 
    do not heavily weight all known factors. They only consider three 
    easily quantifiable known factors. An excellent brand, a growing 
    industry, a superb management team, etc. may also be known 
    factors. However, they are not precisely quantifiable. I would 
    argue that while these factors may not be quantifiable they are 
    calculable; that is to say, while no exact value may be assigned 
    to them, they are useful data that ought to be considered when 
    evaluating an investment. 
    
    There is the possibility of a middle ground here. These three 
    contrarian methods may be used as a screen. Then, the investor 
    may apply his own active judgment to winnow the qualifying stocks 
    down to a final portfolio. Personally, I do not believe this is 
    an acceptable compromise. These three methods do not adequately 
    model the diversity of great investments. Therefore, they must 
    either exclude some of the best stocks or include too many of the 
    worst stocks. It is wise to place great weight upon each of these 
    measures; however, it is foolish to disqualify any stock because 
    of a single criterion (which is exactly what such a screen does). 
    
    Finally, there is Joel Greenblatt's "magic formula". This is the 
    most interesting formulaic approach to investing, both because it 
    does not subject stocks to any true/false tests and because it 
    is a composite of the two most important readily quantifiable 
    measures a stock has: earnings yield and return on capital. As 
    you will recall, earnings yield is simply the inverse of the P/E 
    ratio; so, a stock with a high earnings yield is a low P/E stock. 
    Return on capital may be thought of as the number of pennies 
    earned for each dollar invested in the business. 
    
    The exact formula that Greenblatt uses is described in "The 
    Little Book That Beats the Market". However, the formula used is 
    rather unimportant. Over large groups of stocks (which is what 
    Greenblatt suggests the magic formula be used on) any differences 
    between the various return on capital formulae will not have much 
    affect on the performance of the portfolios constructed. 
    
    Greenblatt claims his magic formula may be used in two different 
    ways: as an automated portfolio generation tool or as a screen. 
    For an investor like you the latter use is the more appropriate 
    one. The magic formula will serve you well as a screen. I would 
    argue, however, that you needn't limit yourself to stocks 
    screened by the magic formula, if you have full confidence in 
    your judgment regarding some other stock.
    
    These four formulaic approaches (the three from Dreman and the 
    one from Greenblatt) will likely yield returns greater than 
    or equal to the returns you would obtain from an index fund. 
    Therefore, you would do better to invest in your own basket of 
    qualifying stocks than in the prefabricated market basket. If you 
    want to be a passive investor, or believe yourself incapable of 
    being an active investor, these formulaic approaches are your 
    best bet. 
    
    In fact, if I were approached by an institution making long -
    term investments and using only a very small percentage of the 
    fund for operating expenses, I would recommend an automated 
    process derived from these four approaches. I would also 
    recommend that 100% of the fund's investable assets be put into 
    equities, but that is a discussion for another day. If, however, 
    you believe you have what it takes to be an active investor, and 
    that is truly what you wish to be, then, I would suggest you do 
    not use these approaches for anything more than helping you 
    generate some useful ideas.
    
    If you choose this path, you need to be clear about what being an 
    active investor entails. Read this next part very carefully (it 
    is correct even though it may not appear to be): I have never 
    found a screen that generates more than one buy order per hundred 
    stocks returned. Even after I have narrowed the list of possible 
    stocks down by a cursory review of the industry and the business 
    itself, I have never found a method that can consistently 
    generate more than one buy order per twenty - five annual reports 
    read. Here, I am citing my best past experiences. In my 
    experience, most screens result in less than one buy order per 
    three hundred stocks returned, and I usually read more like fifty 
    to a hundred annual reports per buy order at a minimum. 
    
    You may choose to invest in far more stocks than I do. Perhaps 
    instead of limiting yourself to your five to twelve best ideas as 
    I do, you might want to put money into your best twenty - five to 
    thirty ideas. Do the math, and you'll see that is still quite a 
    bit of homework. That's why remaining a passive investor is the 
    best bet for most people. The time and effort demanded of the 
    active investor is simply too taxing. They have more important, 
    more enjoyable things to do. If that's true for you, the four 
    formulaic approaches outlined above should guide you to above 
    market returns.  
    



    Writer's Resource Box:
    Geoff Gannon is a full time investment writer. He writes 
    a (print) quarterly investment newsletter and a daily value 
    investing blog. He also produces a twice weekly (half hour) 
    value investing podcast at: http://www.gannononinvesting.com




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