Insider Monkey is reading Seth Klarman’s $1500 book, Margin of Safety, which reflects a reknown value hedge fund manager’s views of investing. It’s not a typo, the price is $1479 for a new one and $750 for a used one. It’s a great book but don’t get us wrong, a value investor shouldn’t pay $1500 for this book. The price is this high because the book is out of print and there are some speculators out there willing to bet $1500. There are other books, such as Joel Greenblatt’s You Can Be a Stock Market Genius, which are as good as Seth Klarman’s Margin of Safety. It’s not like he invented the concept of “margin of safety” and you can’t find the principles of value investing somewhere else.
The underlying assumption of value investing is that markets are inefficient and can deviate significantly from fundamentals occasionally. So, we were a little bit shocked when Seth Klarman said the following about investment formulas:
“Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future. Some investment formulas involve technical analysis, in which past stock-price movements are considered predictive of future prices. Other formulas incorporate investment fundamentals such as price-to-earnings (PIE) ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has been put into devising such formulas, none has been proven to work.
“One simplistic, backward-looking formula employed by some investors is to buy stocks with low PIE ratios. The idea is that by paying a low multiple of earnings, an investor is buying an out-of-favor bargain. In reality investors who follow such a formula are essentially driving by looking only in the rear-view mirror. Stocks with a low PIE ratio are often depressed because the market price has already discounted the prospect of a sharp fall in earnings. Investors who buy such stocks may soon find that the PIE ratio has risen because earnings have declined.
“The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.”
Joel Greenblatt described a magic formula in his book “The Little Book That Beats The Market,” to pick stocks. The book was published in 2005. Insider Monkey, your source for free insider trading data, analyzed the magic formula’s returns during the past one and a half year and concluded that it generated 4.5 percentage points of alpha. The strategy was successful before it was published, and it’s still successful after it was published. This is where the efficient market hypothesis people always stumble. Markets aren’t as quick as they think in eliminating profitable investment strategies.
Insider Monkey is promoting a magic formula that was discovered 40 years ago. It was working then, it was working in 2000 when Lakonishok and Lee republished it, and it is still working today.
Jim Simons became one of the richest men on the planet by employing “investment formulas” successfully. Jim Simons’ Medallion Fund has an annual alpha of 34%. There are several other examples of successful investment formulas. No, it’s not easy to develop successful investment formulas, but it is possible. Once you develop one, you can use it for much longer than the efficient market people expect.