I was introduced to formula investing in Joel Greenblatt's second book, The Little Book that Beats the Market
. The book talked about using a 'magic formula' to screen and select stocks. I was skeptical at first because like most investors, I was opposed to the idea of using a screen to pick stocks rather than doing fundamental analysis. But I was surprised to learn that even Benjamin Graham, the father of value investing, had a 'magic formula'. Graham's formula involved NCAV, liquidation value, and a few other metrics. Greenblatt's formula was much simpler; it only looked at the stock's P/E ratio and return on capital. Stocks with a combination of a low P/E ratio and high return on capital were ranked high on the magic formula screen. Backtests for magic formula stocks showed excellent results -- 30.8% average annual return for the period 1988 - 2004. Recently, Greenblatt opened a formula investing mutual fund, which has done quite well so far.
. The book talked about using a 'magic formula' to screen and select stocks. I was skeptical at first because like most investors, I was opposed to the idea of using a screen to pick stocks rather than doing fundamental analysis. But I was surprised to learn that even Benjamin Graham, the father of value investing, had a 'magic formula'. Graham's formula involved NCAV, liquidation value, and a few other metrics. Greenblatt's formula was much simpler; it only looked at the stock's P/E ratio and return on capital. Stocks with a combination of a low P/E ratio and high return on capital were ranked high on the magic formula screen. Backtests for magic formula stocks showed excellent results -- 30.8% average annual return for the period 1988 - 2004. Recently, Greenblatt opened a formula investing mutual fund, which has done quite well so far.The book certainly changed my view on formula investing. After all, most mutual fund managers, who analyze stocks for a living, do not beat the market. The key to successful investing is not to do as much research as possible, but to have a simple, fundamentally solid strategy and stick to it.
Individual and professional investors alike should not be opposed to using a formula to select stocks. In a 1976 interview with Ben Graham, shortly before he passed away, he had this to say:
Yes, well now I have lost most of the interest I had in the details of Security Analysiswhich I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles.... The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued - regardless of the industry and with very little attention to the individual company.... Imagine - there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.*
I was as surprised as you were when Graham called the ideas in Security Analysis "relatively unimportant".
Hopefully after reading this you have a newfound respect for formula investing and maybe even incorporate it to a portion of your portfolio.
* Read the whole interview here