Monday, 11 September 2006

"Little Book" Investing down under

I read "The Little Book that beats the market" while I was browsing through a bookshop several weeks ago. The author, Joel Greenblatt, is a Columbia Business School adjunct professor, and in this book he proposes that investors can achieve better than "market average" returns using a "value" approach to investing. It's an entertaining read, but I don't really think you need to buy the book unless you want it on your bookshelf - a quick skim through gives you the basic theory behind his approach to stock picking, and the data required to apply it yourself to Australian stocks isn't readily available (as far as I know), and everything you need for US stock picking is provided on a free website (see below). However, if you want to buy a copy for your investment library (or to wave around at dinner parties once you've made a million trading this system), amazon.com has it for about $13US (nb. if you use this link I'll get a 4% commision):



If you've read it in the local library (or bookshop) there is a website (magicformulainvesting.com) that conveniently provides you with lists of suitable US stocks that rank highly under his system. The data is apparently updated daily, so any time you want to pick a stock using his method you just log in, enter a couple of criteria (minimum market capitalisation and how many stocks to list), and voila - you are ready to take the plunge.

Over the years I've drifted into the semi-strong efficient market camp, and so I nowadays invest in Vanguard Index Funds as the "core" of my portfolio, but I still like to dabble in direct investments to add interest (and, if I'm lucky, some performance) to my stock portfolio. I wanted to start adding some direct investments in US equities to my portfolio this year, so when I read this book I decided to take the plunge into direct US share investing using this system to select stocks. The main adjustments required are to ensure that you hold each stock for more than twelve months so you get the 50% capital gains tax discount (in Australia), and to buy fewer than the 30 stocks he recommends to reduce trading costs. I intend to buy a stock each month and hold each of my stocks for 18 months so that my "churn" is reduced a bit. My total US portfolio will thus end up containing 18 stocks - enough diversification to achieve whatever performance this system can yield. The book advises selling each stock after 12 months, but buying US stocks through Comsec (via the US broker Pershing) costs $65US each way, which is a LOT more than the $5US trades available in the States. I'm buying a $5,000US lot each month, which means that my round trip cost per lot will be around $130US ie. 2.6% - or about 1.75% per annum. As Vanguard International Index Funds will cost around 0.75% per annum, you have to outperform the market by at least 1% to match simple indexing.

Prof. Greenblatt's private investment partnership, Gotham Capital, is supposed to have produced 40 per cent a year returns over the past 20 years. My "target" is to achieve 15% per annum return (after trading costs). I am borrowing 100% of the amount I am investing using part of a Portfolio Loan (line of credit) I have from St George bank. This has the same interest rate as our property loans (currently around 7%), so if everything goes well I'd achieve around 8% return using OPM (other people's money). Of course, if things don't work our I'll lose money hand over fist ;). As my total investment will end up around $90,000 US ($120,000 AUD) I expect the worst case would be around $36,000 loss (interest payments and capital if the investments average a 20% loss) - around 5% of my net worth. nb. Back-testing his formula between 1988 and 2004, Greenblatt only had one down year, with the magic portfolio returning 30.8 per cent a year, against a 12.4 percent annual return for the S&P 500. It wasn't clear whether the back testing used random selections of 30 stocks picked from the universe of stocks thrown up by the magic formula - I'll be just picking one from the list each month that catches my eye.

I've been using this system now for three months, having bought H & R Block (HRB), Motorola (MOT) and Microsoft (MSFT) so far. HRB has gone down since I bought it, MOT and MSFT up, so overall I'm up about 3% after round trip costs - I'll post a detailed update on how this portfolio is going each month... wish me luck!

1 comment:

Hendrik Oude Nijhuis said...

Hello, I wish you much success;)

Why taking extra risk by using leverage? Personally I would advice to work without leverage, but that is my opinion.

The results this year of the random Magic Formula-selections are not that exiting. I believe this will continue in the coming years. This because of the –unexpected- rise in commodity prices over the last years.

By this many commodity companies have high returns on invested capital and high earnings yield, which make them to appear on the Greenblatt-screening, although they lack durable competitive advantages (one of the factors Greenblatt tries to screen on). This –although there are more factors- will lead to lower returns for MF-screen than achieved in the past (and as shown in the book),

Success in investing,
Hendrik Oude Nijhuis
www.magicformulastocks.com