Mean reversion seems like an inevitable phenomenon, but when it comes to the stock market, it involves two questions: how does it revert and how long does it take? Both are uncertain. In fact, models built from these factors are not meaningless, they provide us with a way to examine market decision-making behavior. Theoretical models always originate from an idea or the accumulation of empirical rules.
If a strategy works, the user will want to set up a standard process to avoid making mistakes when things get irrational. But many methods, even if useful, aren’t always effective. Useful methods, once discovered, might lose their opportunity to generate excess returns due to overuse, tending towards average returns.
Returning to Greenblatt’s Magic Formula, his original idea was that in a volatile market, the stock price of the same company can rise and fall, even though the intrinsic value of the company remains unchanged. By seizing these opportunities, one can buy undervalued companies.
What I’m curious about is this: if we call the cheap stocks filtered by earnings yield "value stocks," are these value stocks truly undervalued or potential growth stocks for the future? The question is: after removing the capital return rate, is the driving factor behind the rise in high earnings yield stocks due to mispricing at the time or future profit growth?
Greenblatt’s Magic Formula sets the standard for "buying good companies at low prices," where low prices refer to high earnings yields and good companies refer to high return on capital. So, if we remove the return on capital indicator, does it mean "I don’t necessarily need good companies as long as they are cheap enough"? This logic seems familiar and is conceptually similar to what Graham said: ignore the industry side of a company and focus only on whether the asset numbers have a margin of safety, diversify investments, and rely on mean reversion. By diversifying investments in stocks below net asset value, even if some stocks fail to revert, it will still create excellent overall investment returns. Of course, this method has its limits. If these cheap value stocks become fewer, investors might not be able to fully diversify their funds, potentially negatively impacting returns.
There is another type of company that might not be filtered by earnings yield: a loss-making company. This loss might be due to some short-term issues, but if the company has a solid foundation to withstand short-term difficulties and later turns losses into profits, this type of stock is called a "turnaround stock." During the process of turning losses into profits, the growth rate soars, and such stocks usually have a very steep upward trend, showing strong momentum among all targets.
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