My friend who happens to be a wonderfully clear thinker, Geoff Gannon wrote a wonderful review of formulaic investing approaches at the beginning of 2006. It is still valid, in my opinion, and certainly is a "reflection of value investing." Geoff divides formulaic approaches into three categories:
- Valuation according to Benjamin Graham...a net current asset approach
- Valuation according to David Dreman...a contrarian approach
- Valuation according to Joel Greenblatt...an earnings yield and ROIC approach...what I would call a what you get versus what you pay for it approach...the so-called magic formula.
The tried and true Ben Graham approach, the foundation of Buffett's early investing is still bedrock for value thinking. Buying a business rather than a stock, looking for a margin of safety by investing below intrinsic value, and essentially paying less for something than it is worth by taking advantage of others' emotions has been important for all of us who espouse value investing. Bottom-line, this approach teaches that one of the best ways of making money is avoiding overpaying for stocks. It represents a defensive system of investing. The systematic valuation approach taught at GSB Columbia by Bruce Greenwald uses this as the first step. One of my favorite sources for such ideas is"Invest in Value."
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Contrarian methodologies are best pursued by employing screens of low Price/E, low Price/Book, low Price/ Cash Flow, low Price/Revenues, etc. Many pre-built screens exist on sites such as Yahoo or MSN as well as AAII. Be aware of the some of the dangers here. In cyclical businesses, frequently peak earnings are valued at the low multiples. Using a low P/E approach may position you in a security slightly in advance of massive earnings deterioration. Utilizing a low Price/Revenues approach systematically seeks out companies that have the lowest net profit margins. In essence, you are endorsing a company that may or may not be turning itself around.
Finally, the magic formula of Greenblatt. The Little Book does a great job in providing a strong discipline for value investing.
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Some of my fellow contributors to this blog have completed significant research into this methodology. The significance of return on invested capital seems paramount to Buffett as well. To quote: "To evaluate [economic performance], we must know how much total capital—debt and equity—was needed to produce these earnings." Clearly, a strong case can be made for capital efficiency if two companies producing identical earnings have significantly different amounts of capital invested to achieve these results.
Back in July of this year, I penned a few thoughts on "Homogeneous Thinking" and the avoidance of lockstep imitation. The discipline of active investing requires independent thinking but that does not necessarily mean that one should be contrary for contrarianism's sake. It means exercising independent judgment based on the facts as well as some assertions about the future course of a business. The notion of how long a competitive advantage will last is a judgment call that all of us will frame in a different way.
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As the just prior post in Reflections observes, "The markets themselves are far more volatile than the underlying businesses they represent...put another way, investors are more volatile than their investments." As Bogle states very aptly, "Emotional factors magnify or minimize this central core of economic reality."
And that, in my opinion is the crux of following a formulaic approach. Trying to understand the nub of an investment, the economic reality is the pursuit of the great investment manager. Great investors are not emotionless contrary to popular belief. Over the short term, the vagaries of the market make sensible investing look like folly. But over the long run, it pays to be "inversely emotional." When we sense pain and fear in the market, we recognize, perhaps cynically, the value that these emotions create. These opportunities create long-term performance.
