10 'Little Book' buys: A magic formula?

by John Reese, editor Validea

While investing is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.

Back in 2005, he created a stir in the investment world with The Little Book that Beats The Market, a bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach with  just two variables: return on capital and earnings yield.

Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period.

Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices.

The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital.

The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 18.8%; the Greenblatt-based portfolio has gained 58.2% -- that's 6.6% annualized, vs. 2.4% annualized for the S&P.

The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound.

It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009, vs. 23.5% for the S&P.

After beating the market again in 2010, it has struggled the past two years, however. But Greenblatt stresses that the strategy won't beat the market every month or even every year, which is important to remember.

In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisiplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

So far in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 10% already. Here's a look at its current holdings.

USANA Health Sciences (USNA)
Express Inc. (EXPR)
Strayer Education (STRA)
C&J Energy Services (CJES)
CACI International (CACI)
InterDigital (IDCC)
CA, Inc. (CA)
Belo Corp. (BLC)
AmSurg (AMSG)
PDL BioPharma (PDLI)

Learn more about this financial newsletter at John Reese's Validea.

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