Mr Market Pays Fair Prices Over the Long Run

 

All the passages below are taken from Joel Greenblatt’s book, “The Little Book that Beats the Market,” 2010 Edition.

 

I love sailing

 

I'm not very good at sailing.

 

I know this, not just from the fact that my wife and kids are scared to go with me, but from hard experience. Once, through a slight miscalculation of wind and water speed, I was 20 feet away from being slammed by a barge at least three football fields long. I remember this quite well, because I had my wife as a passenger (who hates boats anyway) while I was busy pulling the starter cord on my little five-horsepower outboard engine (darn thing never works when you really need it) as the giant barge blasted its horn for me to get out of the way.

 

Usually sailboats have the right of way over motor boats, but since 9-billion-pound barges don't steer all that quickly, the right-of-way thing gets switched around (good to keep in mind if it ever comes up). So there I was, repeatedly pulling the worthless starter cord while trying to act like I had everything under control (just so my wife's last words wouldn't be "I hate this stupid boat!"), when a final puff of wind helped us sail out of danger.

 

I'm recounting this story not because I enjoy sailing alone. I actually like having company (preferably brave or blind company). I'm telling you this because even though I'm clearly not a good sailor, I still love sailing. And that's the same way many people feel about investing in the stock market. They may not be particularly good at it, or they may not know whether they are any good at it, but there's something about the process or the experience that they enjoy.

 

For some of these people, investing by using a magic formula may take away some of that fun. I understand this. There are also people who are good or would be good at picking individual stocks---without using a magic formula. And that's fine, too. The next chapter should give both groups an idea of what they'll need to know if they want to be successful at picking stocks on their own. It should also show them how the principles behind the magic formula can still be used to guide individual investment decisions. But before even thinking about whether to go forward investing with or without the magic formula, there are still a few more things you should know.

 

First, the magic formula has a better track record than I've been letting on. I didn't reveal this good news earlier for a reason. A good track record is not why you should want to follow the magic formula. A good track record is not why you will have good results in the future. A good track record is not why you will keep following the magic formula even when results turn against you. The truth is that a good track record only helps once you understand why the track record is so good. Now that you do---simply put, the magic formula makes perfect sense---I can trust you not to get carried away with a little more good news.

 

As you recall, the magic formula was tested over a recent 17-year period. A portfolio of approximately 30 stocks selected by the magic formula was held throughout that time, with each individual stock selection held for a period of one year. Performance was then measured over 193 separate one-year periods.1 The stock portfolios chosen by the magic formula usually beat the market averages, but there were one-, two-, and even three-year-long periods when this was not the case. This created the risk that investors might give up on the formula before it had a chance to work its magic.

 

As we discussed, over one-year periods, the magic formula stock portfolios underperformed the market averages in one out of every four years tested. Following the formula for any two-year period in a row (starting with any month during the 17 years), the magic formula underperformed the market averages in one out of every six periods tested. Remember, while that may not sound all that bad, underperforming for two years in a row is actually pretty hard to take! But here comes the good news. Following the formula for any three-year period in a row, the magic formula beat the market averages 95 percent of the time (160 out of 169 three-year periods tested)!2

 

But that's not all! Over three-year periods, if you followed the magic formula, you would never have lost money. That's right. Sticking with the magic formula for any three-year period during those 17 years, you would have made money 100 percent of the time (169 out of 169 three-year periods).3 Of the 169 separate three-year periods tested, the worst return for the magic formula was a gain of 11 percent. The worst return over a three-year period for the market averages was a loss of 46 percent. That's a pretty big difference!

 

But that's still not all. All those numbers you just read about were based on the results achieved by choosing from only the largest 1,000 stocks (those with a market value over $1 billion). The results from choosing from the largest 3,500 stocks (market values over $50 million), a group of stocks individual investors can generally buy, were even better. Every three-year period tested (169 of 169) was positive for the magic formula portfolios, and every three-year period beat the market averages (169 out of 169). That's right. The magic formula beat the market averages in every single period! Hey, maybe there is some thing to this magic formula, after all!4

 

But can we really expect such great results without taking much risk? Well, the answer often depends on how you choose to look at risk.5  Although over the last 50 years professors in the financial field have come up with interesting ways to measure or compare the risks of different investment strategies, most of these involve mea­suring risk in a way that should have no meaning to you. This is true especially if you choose to invest with a truly long-term time horizon. When thinking about risk, rather than making things unnecessarily complicated, there are really two main things you should want to know about an investment strategy:

 

1. What is the risk of losing money following that strategy over the long term?

  2. What is the risk that your chosen strategy will perform worse than alternative strategies over the long term?

 

So how does the magic formula stack up under this definition of risk?  Since it is fairly easy to design an invest­ment strategy to equal the return of the market averages6 (and yet, as we'll discuss later, most professional investors do even worse than the market averages), we can, at the very least, make a reasonable comparison of these two simple strategies. So let's see.

 

During our test period and using even a relatively short three-year time frame, the magic formula strategy did pretty darn well. The returns from the magic formula strategy were far superior to the returns of the market averages. The magic formula strategy never lost money.7 The magic formula strategy beat the market averages over almost every single three-year period tested. In short, the magic formula strategy achieved better results with less risk than the market averages.

 

Though sticking with the magic formula strategy for even three years paid off incredibly well during our test period, this may not always be the case. Even superior investment strategies may take a long time to show their stuff. If an investment strategy truly makes sense, the longer the time horizon you maintain, the better your chances for ultimate success. Time horizons of 5, 10, or even 20 years are ideal.

 

Though not easy to do, even maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum time frame for any meaningful comparison of the risks and results of alternative investment strategies.

 

We now have a better understanding of just how pow­erful and low risk the magic formula truly is, but we still have one problem left to solve before we can move on to the next chapter. It has to do with our old friend Mr. Market, and maintaining a proper time horizon plays a key role here, too.

 

As you may recall from the first day of business school in Chapter 4, it is Mr. Market's constantly changing emotional state that creates the bargain opportunities that the magic formula is able to put to its advantage. But these same emotions create a problem. If Mr. Market is so unstable, how can we be sure that he will eventually pay a fair price for our bargain purchases? If we don't eventually get a fair price from Mr. Market, a bargain could remain a bargain forever (or worse, become even more of a bargain!).

 

So here's the other thing you need to know about Mr. Market:

 

·       Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices.

 

Yep. Over the long term, crazy Mr. Market is actually a very rational fellow. It may take a few weeks or a few months, and not infrequently a few years, but eventually Mr. Market will pay a fair price for our shares. I actually give a guarantee to my MBA students at the beginning of each semester. I guarantee them that if they do a good job valuing a company, Mr. Market will eventually agree with them. I tell them that, though it can occasionally take longer, if their analysis is correct, two to three years is usually all the time they'll have to wait for Mr. Market to reward their bargain purchases with a fair price.

 

How can this be? Isn't Mr. Market an emotional basket case? Well, although it's true that Mr. Market can often be ruled by emotion over the short term, over time facts and reality take over. If the price of a stock has been beaten down unfairly in the short term by an overly emotional Mr. Market (this could happen, for instance, when a company announces some bad news or is expected to receive some bad news in the near future), a few things can take place.

 

First, there are a lot of smart people out there. If the price offered by Mr. Market is truly a bargain, some of these smart people will eventually recognize the bargain opportunity, buy stock, and push the price closer to fair value. This doesn't have to happen right away. Sometimes uncertainty about the prospects for a particular company over the near term will keep potential buyers away. Sometimes the influence of emotions can last for years. But here's the thing. Eventually, the problem or the reason for the emotional reaction is resolved. It could be a positive resolution or a negative one. It doesn't really matter. If there is uncertainty about a company's earnings over the next two or three years, by waiting long enough we eventually find out the answer (even if this takes the full two or three years!). Once the reality of the situation is known, smart investors will buy stock if the bargain opportunity still exists.

 

Second, even if these so-called "smart" people don't recognize the bargain opportunity and buy shares, there are other ways that stock prices can move toward fair value. Often companies buy back their own shares. If a company believes its shares are undervalued, the management of the company can decide that it is a good investment to use its own cash and repurchase some of the company's shares.8 So this action of companies buying back their own shares is another activity that causes prices to rise and may help eliminate some bargain opportunities.

 

If that doesn't work, there are still other ways that share prices tend to move toward fair value. Remember, a share of stock represents an ownership interest in an actual company. Anyone who buys all of the shares outstanding would then own the entire company. Often, if a bargain opportunity persists for too long, another company or a large investment firm may decide to make a bid for all of the shares outstanding and purchase the entire company. Sometimes even the possibility that a buyer for the whole company may emerge can cause share prices to rise toward fair value.

 

In short, over time the interaction of all of these things---smart investors searching for bargain opportunities, companies buying back their own shares, and the takeover or possibility of a takeover of an entire company---work together to move share prices toward fair value. Sometimes this process works quickly, and sometimes it can take several years.

 

Although over the short term, Mr. Market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to Mr. Market.

 

This means that if you buy shares at what you believe to be a bargain price and you are right, Mr. Market will eventually agree and offer to buy those shares at a fair price. In other words, bargain purchases will be rewarded. Though the process doesn't always work quickly, two to three years is usually enough time for Mr. Market to get things right.

 

So now that we have all that good news out of the way, let's see if we can sail through the next chapter without hitting anything.

 

Quick Summary

1. The magic formula works. It works even better than I let on before.

2. The magic formula achieved its far superior results with far less risk than the market averages.

3. Although over the short term Mr. Market may price stocks based on emotion, over the long term Mr. Market prices stocks based on their value.

4. If you couldn't vomit under the 3em-spaces, try sailing with me.  [pg 93- 104]

 

Notes

1. Performance was measured from January 1988 to January 1989, then February 1988 to February 1989, then March 1988 to March 1989, and so on, for 193 one-year periods ending December 31, 2004. This is commonly referred to as 193 rolling one-year periods. Measuring three-year rolling periods would mean measuring performance from January 1988 to January 1991, February 1988 to February 1991, and so on.

2. There are fewer three-year periods tested than one-year periods because the last three-year period that could be tested started in January 2002 and ended December 31, 2004. The last one-year period started in January 2004.

3. In other words, during our 17-year test period, the magic formula portfolios were still profitable even when they didn't beat the market.

4. With this group of 3,500 companies, the worst three-year return for the magic formula portfolios was a gain of 35 percent. For the market averages, the worst three-year return was a loss of 45 percent!

5. Though, in this case, the magic formula looks pretty darn good no matter how we choose to measure risk.

6. Such as an investment in an index fund or an exchange-traded fund (ETF).

7. The market averages lost money in 12 percent of the three-year periods tested. Of course, despite the 100 percent success rate of the magic formula during the test period, it is almost certain that the magic formula strategy will have negative performance periods in the future.

8. This would reduce the amount of cash the company had, but it would also reduce the number of shares outstanding of the company. If ownership of the company is distributed among fewer shares, each remaining shareholder would own a larger percentage interest in the company.