In Plus episode 244 for the week of March 16, 2019, we explore magic formula investing as proposed by Joel Greenblatt in The Little Book that Beats the Market. We discuss commodity trading advisors and analyze one that uses a trend following strategy.
Finally, we discuss how Social Security can be viewed as longevity insurance.
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Show Notes
The Little Book That Still Beats the Market by Joel Greenblatt
Spreadsheet on deciding when to take Social Security
Transcript
Welcome to Money For the Rest of Us Plus. This is the premium podcast episode for Plus members, episode 244. I’m recording this Friday, March 15th, 2019. In today’s episode, we’re going to look at Joel Greenblatt’s Magic Formula for Investing. We’ll review a commodity trading advisor that uses trend-following strategies and talk a little bit about what is trend-following. Finally, I have a question from a member on the timing of social security payments.
Magic Formula Investing
First, I got an email from a member that asked if I could talk about using the tool MagicFormulaInvesting.com. He continues, “It’s how Gotham (an investment firm that Joel Greenblatt and his partners own) pick their stocks. They’ve consistently outperformed the S&P 500 since inception.”
I looked at the website and I couldn’t figure out how they’re picking the stocks. It’s a screening tool for picking individual stocks, but I wanted to figure out how they’re doing it. Greenblatt has done a good job, the book has done very well; he’s got a book called The Little Book that Beats the Market. It came out in 2005. There’s a follow-up book, The Little Book that Still Beats the Market. I’ve never read it, so I bought it, because I couldn’t find the formula and I figured, “Well, it’s worth nine bucks…” So I bought the book, to figure out what is the magic formula.
The formula
The approach is to rank companies based on some valuation criteria and based on profits. The specific measure is earnings yield. It’s a little different than what we show on Money For the Rest of Us Plus, which is effectively the earnings divided by a price. In this case, it’s looking at pre-tax operating earnings to what they call enterprise value, which would be the market capitalization or the value of the equity plus any interest-bearing debt. So it’s a little different, but the idea is: what is the company earning in terms of the total value of the company.
The second-ranking screen is the return on capital, which they define as “earnings before interest and taxes, divided by net working capital,” which would be the current assets “minus the current liabilities, plus any additional longer-term fixed assets”. The idea here is to figure out “Well, what’s the rate of return, the profitability?” This is how they manage money, so you can use the screens to select companies.
How well has Gotham done?
Gotham also manages a number of mutual funds using the strategy, so the first thing I wanted to know is how have they done? The Magic Money Formula—I think I just said that wrong… The Magic Formula for Investing—I’ve been thinking so much about magical money trees and MMT recently… But on that site, they mention one of the funds that Gotham manages, the Gotham Index Plus Institutional. I thought, “Well, that would be an interesting one to look at.” Its ticker is GINDX. But then I saw on Morningstar that the expense ratio was 3.39%, and I thought “What?!”
It turns out they’re getting exposure to the S&P 500, and then they’re adding through swap or options —it’s a portable alpha strategy. Then they have an overlay comprised of 263 long holdings, 234 short holdings; essentially, a long-short strategy. And then whatever excess return that generates gets added to the S&P 500, less fees. Complicated. But you’ve got this drag of this 3.39% expense ratio.
The fund has only been up for three years, and it’s returned 14.1% versus 13.9% for the S&P 500. But gross of fees, pretty incredible performance. It shows that they’ve been able to add value, but it’s that fee drag. But that just suggests that “Hey, maybe there’s some merit to this magic formula.”
I then found a fund that’s more long-only, the Gotham large value institutional fund. The expense ratio is 0.75%. It owns 233 stocks. Now, what caused me to pause there is that the portfolio turnover was 670%, which is extremely high. I mean, you’re holding some securities for only a month or so. The Magic Formula of Investing (or the book itself) talked about holding these securities for at least a year so that it reduces your tax burden, but… The Gotham Large Value Institutional Fund has actually outperformed since inception, 13.6% versus 12.6%. That was through year end 2018.
The three-year performance through yesterday— it underperformed 13.6% versus 13.9%. But with that very high turnover, it means the tax drag—Morningstar estimates that the performance would be about two percentage points lower on an after-tax basis, so much less competitive. Essentially, underperforming the market after fees and taxes.
It not supposed to always work
What’s interesting though is that I like the book—in the sense that Greenblatt was very upfront that this strategy, as in many active strategies, don’t outperform every single year. He writes:
“The Magic Formula portfolio fared poorly relative to the market averages in five out of every twelve months tested. For full-year periods, the Magic Formula failed to beat the market averages once every four years. For one out of every six, the Magic Formula did poorly for more than two years in a row. During those wonderful 17 years for the Magic Formula, there were even some periods when the formula did worse than the overall market for three years in a row…”, such as it’s doing now, at least in terms of that large-cap value fund.
And here’s the key – he continues:
“Do you think it’s easy to stick with a formula that hasn’t worked for several years? Do you think the typical goes something like “I know this hasn’t worked for a long time” or “I know I just lost a lot of money, but let’s keep doing what we’re doing.” I assure you, it is not. So what’s the point? The point is that if the Magic Formula worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain price stocks selected by the Magic Formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the Formula, the bargains would disappear and the magic formula would be ruined.”
That’s true. It is very difficult to hold on to an underperforming strategy, and if everybody did—that’s why value works over time because investors get discouraged. It’s more appealing to invest in fast-growing growth stocks. That’s why everybody piles in, and then when those growth companies disappoint, the stocks crater. Whereas value, if you buy a value index, it’s embedded with positive surprises. It’s a basket of undervalued securities where expectations are low, and that can lead to outperformance over time, and one way to do that like I do it in my portfolios with fundamental indexing or some other type of value smart beta factor, but it doesn’t work all the time. And if everybody discovers something and wants to use it, then that excess return can go away.
I thought about this earlier today. I got a call—I hardly ever get phone calls now, which is great—I didn’t answer, because I didn’t know who it was; it was a Philadelphia number. But I called them back and it turned out to be an investment manager that manages money for one of my former clients. They thought that I was still the investment advisor to this client. Seven years later. I’ve been gone seven years, and they’re calling me up, letting me know that they’re going reduce the fee for this client.
This client is based in New Mexico, and actually, LaPriel and I had dinner with them last year. I hadn’t seen them in five or six years; it’s a private foundation. At that dinner, the client pointed out to me that this manager from Philadelphia that called me was their best-performing manager. This manager our research team recommended terminating about eight or nine years ago, and I don’t even remember why. The performance was struggling, but that wouldn’t have been the main reason. There was something organizationally…
Whenever you have a manager, you’re trying to figure out “Are the characteristics that led to the outperformance continuing? Is the investment culture there, the people, the process?” This analyst had the backing of the investment policy committee, which included me, voted to terminate the manager. It was a hard decision; I don’t remember very well. I believe I probably went to Philadelphia with this analyst to help do the due diligence. I certainly had been there several times on my own, I just don’t recall. But we made the recommendation, I backed the recommendation. This client said “No, we’re not gonna fire him. We’re gonna keep him”, and the manager has done very well. But not every year, and that’s the thing about active management—it’s very difficult, and it’s hard looking forward to say “Is this manager going to continue to outperform?”
It requires patience
The Magic Formula seems to work; it’s a question of how you implement it. Obviously, most of us can’t buy 263 stocks, so then you’re figuring out “Alright, here are the top stocks. I’m gonna hold them for how long…” and it becomes very difficult. That’s my thoughts on that. Try it out. Anytime you’re buying an individual stock, you’re suggesting that you have some type of edge, that the stock is not priced correctly, that it’s undervalued, and it’s an undervalued company, and investors are not paying enough given the level of profitability; that’s what this formula is based on, and that’s what you’re doing, but you have to be patient.
As individual investors, we can be more patient. One of the challenges with professional money management is clients are not patient, because you never know if a manager is underperforming if something has changed, or it’s just one of those normal periods of underperformance, just like these periods of underperformance you have for the Magic Formula.
A trend following strategy
In that regard, I got another email from a different member regarding a manager called Dunn Capital. They’re a commodity trading advisor, using a trend-following strategy, which means they’re investing in commodity futures: agriculture futures, energy futures, I think even some interest rate futures. This member says “I like their 8% annualized return over the past five years. I like the fact that they have a low correlation to the S&P 500. They’ve returned 12.6% compounded since 1984. Their fee structure: they charge 25% of new trading profits”, but they have a callback. If they lose money, they don’t start charging a fee until they’ve actually—actually, it’s called a high watermark, not a callback. If they lose 25% in the first year, they don’t start collecting a fee until they’ve actually gained back, so you’re back to even. But it’s a 25% fee. That’s high, it’s like a hedge fund.
He mentioned “This would be a good time to buy because they’ve had a period of poor performance in 2018. The negative is they’re a black box. They do trend-following, but the details of how they do it are unknown. Their minimum investment is $100,000, maximum drawdown is 30%.”
Here’s the thing about how they’re investing—trend-following means they’re looking at particular commodity futures that are either rising in price, in which case they’re going long, or the trend is negative, which means they’re going short. And they’re buying some combination of these futures. Now, the futures market is a zero-sum game. We talked about this several episodes ago in terms of trading, and should you trade. It’s a zero-sum game; your winnings as a commodities future investor are funded by the losses of those that lost the trade. So you’re competing. And you look at their performance, and it is volatile. Here’s what they show: their total returns for the 60 months ending January was 7%, and there is a low correlation, only a 0.12% correlation, which means you get a diversification benefit by investing in them; as the markets go up, this might be going down… It’s not moving in tandem with the market.
52% of the months they have a positive return, 48% a negative. So it’s just like in that trading episode, there’s just a slight edge. They’re only right 52% of the time, and their average monthly gain is 5.7%, and their average monthly loss is 4.4%. The difference between winning and losing is pretty small when you’re investing in a zero-sum game. The question is “Will they be able to continue to maintain their edge, with more algorithms, more bots out there? Will it persist?”
Commodities market
What’s interesting though is we have to compare, well, how has the overall commodities market done? And from that standpoint, over the past five years they’ve returned 7%, but had you bought a commodities ETF— that’s also just rolling over long-only futures; DBC is an example—it lost 9% to 10% annualized over the past five years. So from that aspect, their ability to go short as well as long has been additive; they’ve added value… But you know, $100,000 is a lot of money. Institutions will —and we used to do that as an institutional advisor—We invested some in commodity trading advisors because those that can do it well are able to play both sides—they can go long, they can go short, and you get the low correlation. But you never know what they’re doing. They’re just deciding that the trend is going to continue, or something along those lines. They have been successful, but it is volatile, it’s expensive, but they’ve done well. So that’s an interesting strategy.
When is best take social security?
I got an email from a member, he turned 66 this May, eligible to take full Social Security. If he took it now, it’d be $2,500/month, so about $30,000/year. If he waits until he’s 70, he’ll get $3,500/month. This is the calculation we talked about back in Plus episode 134, and I did a spreadsheet, which I’ll link to in the show notes of this episode, and you can go through the numbers. But we’re trying to figure out—if you take it now, you can invest that money, versus taking it when you’re 70. The way that this sets up, if he waits until he’s 70, he’ll get an extra 40% per month for the rest of his life, whereas if he takes the money now, he has four years of getting a lower payment that could be invested. At some point there’s a breakeven, where he’s investing that money for four years, then at 70 the option is to take the higher amount; because it is a higher amount, you eventually get enough back to offset that four years of payments you received that you’ve been investing.
From an actuarial standpoint, you would expect that breakeven to be about the individual’s life expectancy, and it is; the break-even amount is around 81 years when I did the calculation. I assumed —and he assumed in his analysis—that you’re earning 3% on the investments, and I assumed a 2.5% cost of living adjustment, because social security, as you know, goes up by some measure of inflation. 81 years is the breakeven. At that point, at age 82, you’re getting $57,000 for the higher amount if you delayed taking it until 70, versus $45,000 for the lower amount if you had taken it earlier. So it’s about a $12,000 difference. And this is where it’s key—delaying social security is most beneficial if you live beyond your expected lifespan, if you live beyond 81, because then you’re getting that higher amount. So by the time you’re 90, you’ve received an additional $109,000 in benefits and earnings on those investments. By the time you’re 90, you’re getting $15,000 more per year, and that’s significant. It’s a form of longevity insurance.
What are other considerations?
So what should he do? His question is, “I’ve done the math. What are other considerations? I plan to continue to work full-time until I’m 69, then maybe take a year off and probably go back to work part-time thereafter. I really don’t need the money to live on, at least for the next three years.”
Well, in that case, if you don’t need the money, I wouldn’t take social security. I’ve done this analysis for family members, where they’ve taken the money because they needed social security to live on. But if you don’t need it, by delaying you get a higher payment, and the benefit of that is a form of longevity insurance. If you live to be 81, 82 or longer, then you would have been better off delaying taking social security.
Other considerations—I’m not a financial advisor, so I don’t know if there’s some tactical tax rule about taxation. At some point, if you’re still working full-time and taking social security—actually, maybe you’re getting taxed on it, or something like that. But if you don’t need it, you just don’t take it.
One benefit of continuing to work beyond retirement age according to social security is you can—if you earn more in those years, you can continue to accrue social security benefits, because social security is based on your highest earning year. So if you’re earning more at age 69 working full-time, you’re earning more than you did when you were 64 (or whenever), you actually would get a higher social security benefit, even if you’re actually collecting it. And then there’s some method that they accrue, but they adjust how much you’ve received, so you can continue to earn additional benefits by continuing to work into retirement age. That’s an interesting feature, I did not know that.
That is Plus episode 244.
