The Book Behind the Strategy
In 2005, Joel Greenblatt published a book that explains how he believes investors may outperform market averages by following his simple process of investing in good companies at bargain prices. Formula Investing is applying this methodology to manage its clients' portfolios.
The Concept Behind Formula Investing
The concept behind Formula Investing is simple. The idea is to systematically follow a strategy that buys above average companies but only when they can be purchased at below average prices. That's it. It is an investment strategy designed to be logical, disciplined, and cost effective. Here's how it works:
- Based on the principles outlined in The Little Book that Beats the Market, stocks are first ranked based on how cheap they are relative to their earnings. In simplest form, a stock that costs $10 and earns $2 per share is considered cheaper and therefore ranked higher than a stock that also costs $10 but earns only $1 per share. (Added adjustments are made to reflect differences in tax rates, debt levels and cash balances between companies.)
- Next, companies are ranked based upon the quality of their underlying business as measured by their "return on capital". In the book, Joel Greenblatt discussed the case of Jason's Gum Shops. It cost Jason $400,000 to open a new gum shop but each store that he opened was able to earn $200,000 per year. A business that can make $200,000 each year from a one-time investment of $400,000 earns a return on capital of 50% (200,000/400,000=50%). In comparison, the book also considers the case of a business called Just Broccoli. Opening a Just Broccoli store also costs $400,000. But each of those stores earns only $10,000 a year. A $10,000 annual return on a $400,000 investment results in a return on capital of just 2.5%. The business with the 50% return on capital is ranked higher and considered better than the one that earns a mere 2.5%. (Here, too, adjustments are made to reflect differences between company tax, debt, and cash levels as well as adjustments reflecting the actual tangible capital employed in each business.)
- Finally, the two rankings are combined and those 20 to 30 stocks with the best combined ranking, those that appear to have the characteristics of being both in a "good" business and appear to be available at a "bargain" price are selected for the Formula Investing portfolio.
Some companies that rank highly according to the methodology may be "cheap" for a good reason. Companies that have earned a high return on capital in the past may not be able to do so in the future due to competition, disappointing new products or for many other reasons. However, we believe that choosing 20 to 30 stocks that rank highly according to our methodology will result in a portfolio that consists on average of companies that are both good and cheap. As Benjamin Graham famously said, "in the short term the market is a voting machine but in the long term, it is a weighing machine". In other words, market prices may reflect volatile emotions in the short term but over the long term the stock market is actually very good at accurately assessing the value of businesses (though this can often take months or years to happen). If this is true as we believe, many of the bargains in our portfolios may be recognized by the market and higher prices may result.
The benefits of a long term strategy like Formula Investing should go to those who are convinced of the logic of owning a portfolio of above average companies purchased at below average prices and who therefore stick with it. This is a strategy meant solely for investors that have a long term horizon, generally 3 to 5 years. Understanding that the strategy makes sense over the long term will be the secret to sticking with it during difficult market periods and hopefully lead Formula Investing clients to long term investment success.
Formula Investing is operated by Gotham Asset Management, LLC.