One of the classic debates in investing is indexing versus active management. The data is clear that few active mutual fund managers are able to beat broad market indexes such as the S&P 500 Index over extended periods. Still, there are some managers who have shown the ability to beat most broad indexes over long periods of time, including those we've named Fund Managers of the Year in past years and those we've recently named Fund Managers of the Decade.
In this piece, I'll approach this classic debate from a different angle. Is there a seemingly ridiculously simple, mechanical, quantitative formula that can beat not only the index but also top-performing actively managed mutual funds that Morningstar has praised over the years and that have themselves beaten the index? Evidence is emerging that there may be at least one.
Graham's Formula
Late in his life, long after he had written the first editions of his two investing classics Security Analysis and The Intelligent Investor, Benjamin Graham gave an interview, reprinted in a book called The Rediscovered Benjamin Graham by Janet Lowe, in which he presented the principles of a simple formula that most investors, including amateurs, could follow relatively easily. This formula had two components or what quantitative analysts these days would call "factors." They were a price/earnings ratio of 7 or less and an equity/assets ratio of 50% or higher. Graham argued that picking a basket of 30 or so stocks that met those two criteria and replacing each stock with another one meeting those criteria--either after the original stock posted a 50% gain or failed to do so after two or three years--would yield very satisfactory results. Graham also allowed for the relaxation of the first criterion in an environment of very low interest rates (such as we are in now), when he said a maximum P/E ratio of 10 was acceptable.
These factors are relatively easy to understand even for many novice investors. Earnings are the proverbial bottom line or profit line on a company's income statement, so the P/E ratio indicates what an investor is paying for a dollar's worth of annual earnings or profits. Basically, Graham argued for never paying more than $10 for $1's worth of earnings.
If you flip the P/E ratio around, you get E/P, or what's called an "earnings yield," a measure that makes stocks comparable to bonds. Although all the earnings of a company don't typically find their way into your pocket in the form of a cash dividend the way interest from a bond does, an earnings yield still allows for a reasonable comparison to bonds. So, for the risk of owning a stock, Graham wanted an earnings yield that was at least twice the yield of a highly rated corporate bond, and he wouldn't consider any stock with an earnings yield below 10%.
The second factor, an equity/assets ratio of 50% or greater, emphasizes a company's financial health or stability, and it's easy to understand for anyone who has ever purchased a home. If a home is worth $300,000, and you place a $60,000 down payment on it and take a $240,000 mortgage, your equity/asset ratio is 20%--you own or have $60,000 worth of equity in an asset that is worth $300,000, and the bank or your lender effectively owns the remaining $240,000, or 80%. In this hypothetical situation, you've borrowed 80%, or well more than half of the price of the home. Indeed, 20% has long been considered a standard down payment on a home (except for the period when the recent housing bubble reached its frothy peak and common sense was lost).
Even 20% equity/assets, however, is more debt than Graham would have wanted for an investment candidate. Graham wanted a company's balance sheet (its statement of assets, liabilities, and equity--in other words, its financial condition) to show that the firm had not borrowed more than 50% of the value of its assets. (Incidentally, this effectively eliminates banks from the investing universe.)
Graham implied that he had back-tested this formula, saying that investors could expect a 15% or more annualized return plus dividends and minus commission expenses, but he didn't provide clear statistics in his interview for how his formula actually performed. However, according to investment firm Tweedy Browne's pamphlet "What Has Worked in Investing," finance professor Henry Oppenheimer ran Graham's screen for stocks listed on the NYSE and AMEX from 1974 through 1980. Oppenheimer found that an investor employing Graham's method over that time achieved an annual return of 38% compared with 14% per year return calculated by the Center for Research in Securities Prices, or CRSP, of NYSE-AMEX securities. A seven-year period doesn't completely prove the validity of a formula, but that time frame is arguably long enough to suggest that the formula may be onto something.
Joel Greenblatt's 'Magic Formula'
Is there an equally simple formula with longer, more convincing back-tested data? A few years ago, hedge fund manager and Columbia Business School adjunct professor Joel Greenblatt wrote a book called The Little Book That Beats the Market, in which he gave the details of a "magic formula" for investing that resembles Graham's in some ways. Indeed, Greenblatt has remarked to us that he's always been intrigued by Graham's work and, if not the formula explained above specifically, certainly the general idea of paying a low price for a company's earnings.
Greenblatt has slightly modified Graham's P/E or earnings yield factor by replacing it with what analysts call "EBIT," or earnings before interest payments and taxes, which adjusts for the fact that different businesses operate with different levels of debt. Greenblatt also replaced the stock price with a firm's enterprise value, which is its total market capitalization (stock price times total shares outstanding) plus its debt. Indeed, EBIT/Enterprise Value has become a widely accepted version of the more traditional Graham earnings yield.
In the spirit of Graham's most famous student, Warren Buffett, who emphasized the quality of the business a bit more than Graham, the second component of Greenblatt's formula is a metric called return on invested capital, or ROIC, which basically relates a firm's income statement to its balance sheet by comparing profits (again, EBIT, in Greenblatt's case) to the capital required to generate them. According to Greenblatt's formula, if you pick the 30 or so stocks that display the best combination of high earnings yield, as he defines it, and high ROIC each year, you'll beat the market over the longer haul.
If we combine the data in Greenblatt's book with the data on his website, formulainvesting.com, we see that the formula posted approximately a 19.9% annualized return from the beginning of 1988 through Sept. 30, 2009. Over that time, the S&P 500 Index returned 9.4% annualized. These returns don't account for taxes, transaction costs, or management fees, which would undoubtedly reduce the strategy's overall performance. However, these frictional costs would erode just a fraction of the strategy's excess annualized return of 10.5 percentage points. The results are also unaudited.
How Did Some Big Funds Stack Up?
The following table shows how some notable funds with $1 billion or more in assets performed from 1988 through Sept. 30, 2009. Many of them are on our Analyst Picks list. The top three funds, Federated Kaufmann, FPA Capital, and Fidelity Contrafund, added considerable value over the index's 9.4% annualized return, with 15.5%, 14.6%, and 13.8% annualized returns, respectively.
We included Vanguard 500 Index Investor to show what an investor seeking to replicate the index's returns would have experienced: a 9.2% annualized return as opposed to the 9.4% return of the index.
We also included a composite of American Funds' seven funds dedicated primarily to domestic stocks. American Funds Growth Fund of America (NASDAQ:AGTHX - News) produced the best return of its siblings, with an 11.5% annualized return. Although the composite beat the index, one of American's domestic-stock funds, American Funds American Mutual, trailed it, posting a 9.1% annualized return for the 21.75-year period.
Other notable laggards were Vanguard Windsor, T. Rowe Price Growth Stock, and Fidelity Equity-Income.
Why Does the Formula Beat the Funds?
It's unreasonable to say that investors haven't been served well by funds that have consistently added value over the index, but the formula's performance makes me wonder about the value of professional management in the mutual fund format, though not exactly in the way that devoted indexers wonder about it. The market isn't efficient, as the indexers say, but its inefficiencies are apparently not easily exploitable for some of the finest pros either--at least given how many of them currently go about investing, trying earnestly to predict future profits and discounting them back to the present. Perhaps managers outthink themselves or have too much confidence in their predictive abilities instead of relying on past results.
It may also be that a typical mutual fund, which maintains daily liquidity, is too unwieldy for many managers (or any manager, for that matter), with investors (both retail and institutional) throwing money in and yanking it out at exactly the wrong times. Academic studies of trading costs are beginning to show that active managers add value when their trading isn't forced by flows and detract value when it is.
Additionally, investing in mutual funds necessarily entails investors buying "legacy" portfolios, as Greenblatt puts it, containing stocks that aren't as cheap as they were when the manager first purchased them. Greenblatt, instead, has chosen to use separate-account vehicles, with every investor purchasing the stocks that meet the formula on that day of investment.
Perhaps many popular mutual funds also just have too much money to exploit the cheapest stocks, which may be more likely to show up in the bottom part of the top 1,000 stocks ranked by market capitalization. (The bottom of the top 1,000 consists of companies around $1 billion in market capitalization.) Buying a meaningful position in stocks this size for many funds necessarily entails pushing prices up and destroying the opportunity. Greenblatt has tested the formula for both the largest 3,500 and the largest 1,000 stocks, and having access to 3,500 stocks increased the performance significantly. It would be nice to know what part of the top 1,000 added the most value in his test of that group.
Finally, doing his best imitation of Yogi Berra and speaking for every variation of value investing, Greenblatt remarks in his book that the formula works precisely because it doesn't always work. In other words, it goes through periods--even multiyear periods--of underperformance. What's cheap can get cheaper or at least stay cheap for an extended period, whether it ultimately deserves to or not. This causes investors to lose confidence and give up. Eventually, though, the market properly recognizes the value of profits, and underpriced profits are what present the opportunities to begin with, benefiting the investors who stick with the formula.
Presumably, industry veterans know about simple formulas like Graham's and Greenblatt's. Indeed, Tweedy Browne's wonderful pamphlet "What Has Worked in Investing" explains many of the simple formulas Graham used and marshals the evidence of academic studies to support them. Yet none of Tweedy's funds have employed any of the formulas strictly. And that's been to their detriment because Tweedy Browne Value, though it doesn't stretch back to 1988, hasn't come close to matching Greenblatt's formula over the past decade despite surpassing the index.
Investors may well want to give Greenblatt's strategy a long, hard look for at least a portion of the stock piece of their portfolios. Greenblatt's minimum investment isn't low at $25,000, though his 1% annual fee, which includes commission costs, is quite reasonable. The strategy, whether you choose to have Greenblatt execute it for you or try to do it yourself by using his other website, magicformulainvesting.com, will require patience. Like all other variations of value investing, it will almost certainly underperform for a multiyear period or post significant losses in a given year, meaning that it's not magic in the sense many investors would like it to be. Indeed, Greenblatt's strategy lost a painful 36% in 2008, only beating the market by 1 percentage point. Still, the evidence is strong that even investors who know "what has worked in investing" simply can't or won't stay with simple formulas or will make investing more complicated than it needs to be. This bodes well for those who can stick with a simple value formula over the long haul.
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