Harry Domash's Winning Investing


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

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