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At current price levels, most analysts and market commentators agree that stocks in general look like attractive investments for "long-term investors". This begs the question of course, what is a long-term investor, and how long should we expect to hold stocks to earn a profit if buying today?

There are several different target holding periods. Wall Street in general has a rather short one, usually 3-6 months. Fund managers usually receive bonuses based on quarterly or annual performance, making it hard to focus on the truly long term picture. At the other extreme, there is the "buy and hold" crowd, which consists of some very successful investors such as Warren Buffett, who has said his favorite holding period is "forever". The federal government defines "long-term" as one year, the cutoff between gains being taxed as income or capital gains.

Of course, most value investing involves buying stocks at below intrinsic value and selling when the price meets or exceeds intrinsic value, with a margin of safety on each side to account for the imprecise science of determining what that value actually is. There is no set holding period in this case. It could be a short-term irrational sell-off that corrects itself in a matter of months, or a stock that continually increases it's intrinsic value, in which case the holding period could be decades.

The Magic Formula Investing (MFI) strategy takes a structured selling approach. One of the advantages of the strategy is it's simplicity. Determining intrinsic value is difficult for beginners, and not that easy for experts either. Joel Greenblatt himself (a very successful fund manager) stated that determining when to sell is the hardest question in investing. So the MFI strategy takes advantage of the tax rules and sets it's target holding period at one year.

One year, however, is a bit short for most value based investments to reach fair value. Even in The Little Book that Beats the Market, Greenblatt states that it can take 2-3 years for the market to price a stock at fair value. That begs the question: is one year too short of a holding period for Magic Formula investors? Lets look at three scenarios to provide some perspective on the question. For each scenario, we will assume that commission costs are not a factor. They should not be, as there are a number of ways for individual investors to avoid them (Zecco is a no-commission fee broker and a MagicDiligence affiliate). This makes tax the only cost of investing.

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First, let's assume that any stock purchased under MFI is sold at the one year mark according to the strategy. By selling at the one year mark, and moving the money to a new MFI pick, we are (in theory) putting that money into a more attractive investment for the next 12 months. The new pick should be expected to outperform the pick we sold. I believe that sticking to this plan is the best choice for most MFI investors. It keeps things simple and avoids requiring any knowledge of fair value, while still remaining logically sound.

The second scenario is what to do if, after one year, an MFI pick remains on the screen? Do we sell and move into a new position or hold for another year? At MagicDiligence, where Top Buy picks are strong companies with long term competitive advantages, the choice is a no-brainer... we renew the position for another year. Great companies at great prices are what the Top Buy picks are, and we will hold them as long as they are MFI stocks. If we like the company, and the stock price is still cheap, why sell and move into another potentially less attractive investment? What's more, we are still following the MFI strategy as written - if a Top Buy pick drops off the screen, it will not be renewed. MagicDiligence feels that this is the best way to incorporate due diligence into the MFI strategy to improve it's returns, and this approach is working.

The final scenario is what I see a lot of MFI investors trying to do - modify the strategy based on technical or fundamental biases. This involves choosing MFI stocks based on the screens, but then deciding when to sell based on other factors. This is not helpful, in my opinion. Several studies have shown that, in mechanical investing, using 2 criteria improves results but using more than that does not help. In any case, when modifying the sell rules you are throwing out all of Greenblatt's research which proved the efficacy of the Magic Formula strategy.

In conclusion, if you have chosen to follow the Magic Formula strategy, don't alter it! MagicDiligence adds up-front value through research before buying, but does not change the strategy at all once purchases are made. It's perfectly acceptable to hold MFI stocks 2, 3, even 5 years or more, but only if they remain on the screen! As a final note, I want to mention that any money you need in the next 5 years should not be in the stock market. The market is just too volatile to risk short-term funds in, and you do not want to be caught at a market low when you need to sell stocks. Money you don't need in that time should be in the market, as it has historically been the best vehicle for building wealth.

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Comments

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Posted by daveoddy on 2008-10-13 18:24:41

That was perfect - thanks...

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Posted by dloomis on 2008-10-16 18:54:43

I'm curious - has anyone analyzed if the MFI strategy works in a protracted range-bound market...similar to what occurred from 1965 to 1983? I know Greenblatt had amazing results during the last bull run (1983 to 2000) but I'm skeptical if the same can be applied elsewhere.

Great blog btw...

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Posted by Steve on 2008-10-16 20:07:31

The MFI research was done for the 1988-2004 period. It's a fairly representative period, though probably more optimistic than most. In addition to the ridiculous bull market in the late 90's, the study also included two recessions in 1990-92 and 2001-03.

The Compustat data Greenblatt needed only went back to '88. However, James O'Shaughnessy did a lot of mechanical screen studies that went all the way back into the 50's, if not farther. They clearly showed that value based mechanical screening outperformed any other metrics. It's likely that MFI would have done well during the 70's bear market.

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Posted by wlamb9 on 2008-10-27 20:13:57

This applies only to taxable accounts, correct? The tax strategy of selling losers at 1 year should not make any difference with my 401k. I suppose the practical effect of this is just that for a stock still on the screen at 1 year you don't have to sell and rebuy after 30 days if you are dealing with a non-taxable account?

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