Larry, I was impressed by your comments in SMR 151 and bought and read Greenblatt's new book.

I fully grasp your emphasis on his Chapter 8 regarding the psychology behind why most investors will not stick with a winning "formula" when the inevitable drawdowns occur.

What I would like to check with you is one thing about Greenblatt's value-based approach I simply do not understand.

In a nutshell, what happens in meaningful stock market crashes like 1987 or (more importantly) like 1929?

I noticed that Greenblatt's backtesting conveniently started in 1988 which bothered me a bit since that left out the 1987 crash.

When the market "tide" goes out and prices tend to drop dramatically across the board, are those "good companies at bargain prices" going to turn out to then be "good companies" bought at very high prices that dropped significantly?

Or are those "good companies at bargain prices" going to tend to do well anyway through a crash and its aftermath?

Since the statistics are everything with this approach (if not all approaches) I wonder if you might comment.

Thanks!

Clint,

Here goes...

In a nutshell, what happens in meaningful stock market crashes like 1987 or (more importantly) like 1929?

In 2000, the S&P was down 9.1%. Magic formula was up 7.9%. In 2001, the S&P was down 22.1%. Magic formula was up 69.6%. In 2002, the S&P was down 22.1%. Magic formula was down 4.0%. So maybe that helps.

The whole idea is that you have a built in margin of safety so that if the market goes down like it did from 2000 to 2002 good businesses purchased at bargain prices will not go down nearly as much and may, in fact, go up.

As far as 1987 is concerned, the stock market went down 25% in one day. And that was pretty much it. If you blinked you missed it. So what would you expect a typical magic formula stock would do? Go down maybe 12%? What's the big deal about that?

I can't tell you much about 1929. That's even before my time. . But as a general comment about crashes, it's ridiculous to plan an investment strategy around a possible event that happens every 50 years or so. As he says in the book your alternative is to put your money in a 10-year Treasury bond. Right now you'll get 4.5%. If you want anything higher than that, you're going to have to take some risks.

I noticed that Greenblatt's backtesting conveniently started in 1988 which bothered me a bit since that left out the 1987 crash.

He didn't "conveniently" start in 1988. He's using Compustat's point in time data base which goes back 17 years. Look, Joel Greenblatt doesn't need to manipulate data to sell us books in order to make money. He needs more money like I need more headaches. If you don't know anything about him, just trust me on that. Some extremely successful people get to a certain stage in life that they want to give something back to people. They truly want to help other people. That's all he's trying to do. If he were trying to make a lot of money on this, I could certainly come up with a better business model than what he's come up with.

Clint, stay away from this until you really "get it." Otherwise, there's no way you'll be able to stick with it. I suggest you read the book again. It seems simple because he writes like he is communicating with a 6th grader. But he is actually talking about some very sophisticated investment concepts. He wants this book to be for the public. But I don't think the public is going to be able to understand it. I think it will become a cult book among investment professionals just like his first book was.

Larry

Thank you, Larry.

Yes, I had been operating from the concern that a crash like 1929 could take decades to recover from with a "buy and hold" strategy and wanted to be certain that being buried in equities - even with "good companies at bargain prices" would not result in a severe loss.

I have only read the book once and will indeed read it over and over until I am quite certain I "get it".

You resolved the only real concern I had.

Thank you again.

You could always give yourself an amount to risk and keep the holdings with a stop loss in case something happens where things really do go south. I learned my lesson post-2000 to always have a stop loss strategy so I dont have a something that goes from 75 to 5 in a space a few months.
Then you can go using an inverse strategy.

Larry, the more I review Greenblatt's book the more impressed I become.

I can now understand on several levels why you took the time to share this remarkable approach in the SMR #151.

As you reminded me in this thread, his detailed 17-year backtesting actually showed profits in both bear and bull periods. (And I am aware that there certainly could be losses as well, as Professor Greenblatt pointed out himself).

Now I am trying to imagine why further diversification would be necessary.

Frankly why would there be a need to use any other trading method or to diversify outside of stocks?

Is there?

Also Kevin suggests the use of a stop loss and I assume that Greenblatt did not suggest this because in some fashion the use of a stop loss would cut into profits.

Am I correct about this do you think?

Thank you again for reviewing and commenting on this book!

Clint,

Frankly why would there be a need to use any other trading method or to diversify outside of stocks?

So you go from worrying about the Crash of 1929 to deciding that diversification outside of stocks is unnecessary. Just kidding. You're right. If you do it properly it's not necessary. There are 10,000 businesses for sale. That's a lot of potential diversification.

Also Kevin suggests the use of a stop loss and I assume that Greenblatt did not suggest this because in some fashion the use of a stop loss would cut into profits.

Greenblatt is a value investor from the school of Warren Buffett and before him, Ben Graham. His philosophy is that when you buy good businesses at a bargain price you already have a "margin of safety" built in. So stops and technical analysis wouldn't be necessary.

But remember this. He emphasizes over and over again that unless you're experienced and good at predicting future earnings then you should diversify into 20 or 30 magic formula stocks. He makes a big deal about that.

Larry

"Greenblatt is a value investor from the school of Warren Buffett and before him, Ben Graham. His philosophy is that when you buy good businesses at a bargain price you already have a "margin of safety" built in. So stops and technical analysis wouldn't be necessary.

But remember this. He emphasizes over and over again that unless you're experienced and good at predicting future earnings then you should diversify into 20 or 30 magic formula stocks. He makes a big deal about that."

Very good point, Larry (don`t want to be nagative all the time), perhaps this is the common sense of Greenblatt, O`Shaughnessy, Graham, Buffett and so on.
If yes, the remaining thing to decide would just be the weighting of the different ratios, like 40% PSR + 30% PCFR + 10% Price-Book-Value + 10% Price-Earnings-Ratio + 10% ROE
and for O`Shaughnessy fans like me a pinch (or is it "dash" in english?) of Relative Strength.

Of course the above example would be much to complicated as a pratical approach. Perhaps an alternative would be: Buy 15 O`Shaughnessy "New Cornerstone Growth-Strategy"-stocks and 15 "Greenblatt Magic Formula"-stocks and substitute them each quarter or each year?

Larry,

You said, "Greenblatt is a value investor from the school of Warren Buffett and before him, Ben Graham. His philosophy is that when you buy good businesses at a bargain price you already have a "margin of safety" built in. So stops and technical analysis wouldn't be necessary."

But for us "grasshoppers", we should still have a stop-loss plan (SAR, etc), and postition sizing in place before we make the trade, right?

I think the position sizing would tell you if your account size would allow 20-30 stocks.

Steve

Larry, Steve was just asking about position sizing with regard to Professor Greenblatt's method.

With 30 stocks being held at any one time and looking at the "margin of safety" from the underlying concept ("buying good companies at bargain prices"), isn't the requisite position sizing already "built in"?

For example, with 30 stocks each risking 3% of the total capital wouldn't that be 90% of the capital?

Looks pretty close to me. Am I missing something?

Steve and Clint,

You're both right. Steve is right that the advantage of stops is that you can identify your risk before hand and, therefore, limit your positions to fewer stocks. Clint is right that if you do it the way Greenblatt suggests, you are automatically limiting your risk. After all, if you have 30 stocks the most you could possible lose on any one is 3.3% even if one went to zero.

There are new types of online brokers like Foliofn.com. They seem particularly well suited for the way Greenblatt recommends to do it. You can just put up a certain amount (there is no minimum), choose the stocks you want, choose the percent of your account you want in each stock, and it is automatically allocated for you. You can have fractional shares.

In other words, you could open an account with $10,000 for example. Choose 20 or 30 stocks from the magic formula list. And your account would be automatically allocated among those stocks by dollar amount rather than number of shares.

It's like being your own mutual fund manager.

Larry