Magic Forrmula Question

Discussion in 'Strategy Development' started by dubs1013, Jan 5, 2012.

  1. dubs1013


    Hi Everyone,

    New to the site but I just finished reading Joel Greenblatt's little book that beats the market. I was intrigued by the idea and selected 30 stocks from his website's screener to track over the next 12 months. However, I can't help but wonder about the feasibility of investing this way for someone who does not have a lot of capital. I would imagine one would need atleast $10k to do this realistically, just to make up for the transaction costs. Has anyone heard of ways that a 'smaller' investor could implement this strategy?

  2. The easiest method would probably be to pick your stocks, find which major index to which they correlate the best, and then weight your ETF accordingly. For example, if you have 20 small cap and 10 big caps, put 2/3 in IWM and 1/3 in SPY (or their equivalents).

    There are some brokers that allow you to trade specific ETF "commission free" (Fidelity does IWM, for example).

    If you go to ETFdb and look at your particular index symbol, it will tell you if and where it is commission free.
  3. 4awhile


    As a newbie, your first and most profitable is to take the following position:

    sit down in your chair in front of you favorite broker's screen, and put your hands under you legs. so your position would be: chair, hands, legs.

    you sit there for a long time thinking about:
    (1) how much of that capital are you willing to lose
    (2) what would you like that money to grow into
    (3) what time frame do you want to achieve you goal

    then, study some technical books, web sites, etc. get a method that looks doable for you. and then forget about all of it.

    buy the SPY etf. Very very few mutual funds beat the S&P 500s. Set a stop say, 7-10% below your purchase price.

    Don't look at your account for 30 days. Dont look at CNBC. At the end of 30 days, readdress your stop loss value. If you've been stopped, buy it again.
  4. bc1


    First off, I guess you need to fill us in on what Greenblatt's magic formula is before anyone can give a rational answer and just how much capital do you have? Some brokers give free trades for a while when you open an account.
  5. How many times does it trade per year? If it trades once per year (like Dogs of the Dow) then you can do it with just about any size account. If it trades every day then commissions may make trading with a small account impossible.

    Look at commissions as a percentage of your position sizes.

    Say for example you have an account with Scottrade and it's $7 to buy and $7 to sell.

    If you open a $700 position (for example, 10 shares of a $70 stock), your position will have to go up 2% in order for you to break even. A 2% gain would bring your position value to $714. If you were to sell at this point it would look like this:

    Initial cost: -$700
    Commission to buy: -$7

    Position value at sale: $714
    Commission to sell: -$7
    Net: $0

    Now, let's say you instead open a $7,000 position. You again pay $7 to buy and $7 to sell. This time, price only has to go 0.2% for you to break even. But because your commission is a much smaller percentage of the position value, it really doesn't matter.

    For another example, something like a $200 position size might be cost prohibitive. If you're paying $7 to buy and $7 to sell, that would mean your stock would have to go up 7% just for you to break even. What if you stock only goes up 5% by the time you have to sell? Most people would be happy with a 5% gain, but for such a small position that would result in a net loss after commissions.

    Of course, your broker may have different commission rules. I just used Scottrade as an example.
  6. pbj


  7. dubs1013


    Thanks for all the replies everyone. I should have been a bit more clear in the first post. The magic formula is a basic stock picking technique that has historically (the past 17 years) outperformed the S&P 500. It is a value picking strategy that uses only two components; cheap stocks (low P/E) that have high ROC's. However, you have to hold the stocks for periods of only one year (and you hold 30 at a time) so transation fees add up. I myself am not a first time to investing as I just earned my degree in Finance. I understood all the concepts of the strategy, but wanted to get more information from you guys on actually implementing something like this, as I don't have a lot of 'hands on' investing experience (dealing with things such as transaction costs etc).

    I was unaware of the mutual funds that Greenblatt has been running since 2010, so that seems pretty feasible for a small time investor. What would be the best platform to try and do something like this? Probably the site that has the cheapest transaction fees (Scottrade?)?
  8. N54_Fan


    Realize that his funds seem to charge a 1.25% expense ratio (yearly fee). So this value fund that has barely outperformed the market is probably underperforming when you take the 1.25% expense into account. If you want to keep up with the S&P easily join Fidelity and you can choose a number of ETFs that are commission free. If you decide to buy some that are not commission free then it costs $7.95. Scottrade also offers some commission free ETFs if I am not mistaken but I am pretty sure Fidelity's list is bigger (more options). I used to have a Scottrade acct and I'm in the process of moving to IB partly for costs and order types available. However, for someone like you that would hold stocks for long periods of time then Scottrade is pretty good. It is just NOT good for swing trading and day trading.

    Good Luck
  9. no kidding, the one I looked at had an expense ratio of 1.55. That is way too high for any system or index type fund.

    better idea would be to buy the best stock in the fund once a year and after thirty years you would own thirty stocks.

    I know of no way an individual with less than 10k can beat the market trading individual stocks because as the OP correctly noted the expenses will eat him alive.

    Value investing and trading are two different things. Typiycally expenses mean almost nothing to the value investor because of the long holding time. For the trader commissions and just the spread can turn any system which on paper makes sense into a loser.

    I can see how the magic formula would work. Just buy value stocks and dump then after a year if the value changes or they just have not moved.

    But generally value investors buy the company not the stock. You buy it because you want to own that company and the stock in your opinion is undervalued by those scumbag speculators and traders.

    OP needs to decide if he wants to trade or value invest, but combining them with odd lots seems to be the worse of both worlds when you consider expenses. 1.55 is way too high even for a mutual fund that dumps stocks it bought based on value and it's the dumping that drives up the costs. Plus in good years the cap gains could make it enefficient tax wise.

    If I'm paying 1.55 the manager better have a better idea than a system. I'm paying him not based on what he knows but who he knows.
    #10     Jan 6, 2012