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Little
Book Does Beat the Market
The best selling stock
market book these days is “The Little Book That Beats the Market,”
written by hedge fund manager Joel Greenblatt. The reason for the Little
Book’s success is no mystery. It describes a simple “magic formula,” that,
according to Greenblatt, would have averaged a 31%
annual return from 1988 through 2004.
To put that number into
perspective, if you started with $1,000 in 1988, by then end of 2004, you
would have had $75,000 with a 31% return
compared to $6,000 if you achieved the market’s 12%
or so average annual return over the same period.
What’s more, you don’t
have to spend hours scrutinizing financial statements or analyst reports
to emulate Greenblatt’s stock picking strategy. He uses only two selection
parameters; return on capital, and earnings yield.
Simple Formula
Return on capital is a profitability measure that compares earnings
to shareholders equity (plus debt). Earnings yield is simply the familiar
price/earnings ratio (P/E) turned upside down. That is, earnings yield is
12-months per share earnings divided by its recent share price. In both
cases, Greenblatt defines earnings as income before deducting interest and
taxes.
While he doesn’t reveal
the exact details of his stock grading formula; in essence, the stocks
with the best combination of profitability (high return on capital) and
low valuation (high earnings yield), rank the highest. Thus, Greenblatt’s
magic formula is a value strategy that involves buying highly profitable
companies that are trading at relatively low prices.
No
Work Involved
Here’s the best news. Unless you’re curious, you don’t have to know
any of these details to find Greenblatt’s highest ranked stocks. He
provides a free screen on his Magic Formula Investing website (www.magicformulainvesting.com)
that you can use to find them.
Once you’ve registered,
you need only pick a minimum market capitalization and select whether you
want to see the 25, 50, or 100 top ranked stocks meeting that
specification. If you’re rusty on stock market terms, market
capitalization is a measure of company size. It’s computed by multiplying
the recent share price by the number of shares outstanding. For example,
the market-cap of a company with 100 shares out trading at $25 per share
would be $2,500 (100 multiplied by $25).
Greenblatt also tested
his magic formula returns by limiting the field to the 1,000 largest
stocks (roughly $11 billion minimum market-cap), which, presumably, are
the safest plays. Adding that restriction cut his average annual return to
23%.
How to Do It
To emulate his magic formula strategy, Greenblatt suggests buying
five to seven top-ranked stocks every two months, or seven to nine stocks
every three months. The goal is to build a portfolio of 20 to 30 stocks
after nine or 10 months that you hold for one-year. When the year is up
for each stock group, you repeat the process and replace any stocks that
don’t appear on the new list.
The reason for taking
nine or 10 months to build a portfolio instead of buying 20 to 30 stocks
at once is to emulate the strategies that Greenblatt tested for his book.
Greenblatt says that buying all stocks at once might work well, but he
didn’t specifically test that strategy, so he doesn’t feel comfortable
recommending it.
Special Brokers May Be Needed
Building a portfolio of 20 to 30 stocks may be impractical for many
investors using conventional brokers. However, there are two Web brokers,
ShareBuilder (www.sharebuilder.com)
and Foliofn (www.foliofn.com),
which are designed specifically for this type of portfolio investing.
Too Good to Be True?
Greenblatt’s magic formula strategy sounds too good to be true,
and, indeed, that could be the case. For starters, once a strategy becomes
widely followed, it often stops working.
Also, Greenblatt didn’t
achieve his 31% average annual return based on
actual stock purchases. Instead, he computed them after the fact using a
technique called “backtesting,” which involves making ‘pretend’ purchases
based on data that would have been available to you at dates in the past.
So Greenblatt probably used backtesting to pick stocks at various dates
starting in 1988, and then tabulated the returns assuming that he sold
them 12-months later.
Backtesting has
problems. For starters, it’s tempting to tailor a stock picking strategy
to optimize its backtested returns. Secondly, there is no guarantee that
the market and economic conditions that existed in the backtested period
will prevail going forward. It’s also possible that the database used for
the testing may not have accurately emulated historical conditions.
Independent Checks
Barron’s, the weekly stock market
newspaper, described tests done by a variety of researchers to check
Greenblatt’s results, in its March 27, 2006 issue. Most confirmed that
Greenblatt’s magic formula would have beaten the overall market in recent
years, but not necessarily by the margins that Greenblatt claims.
In my view, Greenblatt’s
work is worth your attention. The fact that he makes his database
available to everyone for free is outstanding. A caveat though, his lists
are computer generated and some stocks may have problems that haven’t yet
showed up in the numbers. Do your due diligence before taking action.
published 4/2/06 |
