Hands Off This Simple Strategy

Joel Greenblatt tried to strike a bargain with readers of his bestseller, The Little Book That Beats the Market. Just do what I tell you, said the author and hedge-fund manager, be patient, and over time your investment return could be twice that of the overall market.

How simple is his method? You go to a free Web site, answer two easy questions and tap the Enter key. Back comes a list of stocks. Buy them, wait a year and repeat, selling your old stocks and buying a new set. Don't worry, be happy, get rich.

In two years, 330,000 English-language copies of the $19.95 book have been printed, plus editions in ten other languages, with more on the way. More than 200,000 people have registered to get Greenblatt's stock lists at MagicFormulaInvesting.com. "Everything clicked," says Joan O'Neil, executive publisher for financial titles at John Wiley & Sons. "The packaging helped enormously, along with the style in which Joel wrote the book. When you can do that, bingo!"

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There's just one nagging little problem: It seems that nobody wants to follow the rules. The evidence in blogs, Web discussion groups and e-mails from our own readers suggests that people equate simplicity with inferiority. "If this simple strategy is so good," people are saying, "then I'll get even better results by tinkering with the formula." Oh yeah? Greenblatt can prove that his simple formula works; the tinkerers cannot prove that their enhancements add value.

Greenblatt, a father of five, wrote The Little Book in language his three teenagers could understand. For example, he uses an allegory about Jason's Gum Shops to explain the guiding principles of investing. Says the author: "I boil investing down to figuring out what a company is worth and paying a lot less." Period.

Of course, few of us possess the skills to determine a company's value. And if you cannot do that, says Greenblatt, either you should forgo investing in individual stocks or adopt his Magic Formula.

The Magic Formula looks for good businesses selling at bargain prices. Greenblatt defines a good business as one that earns a high return on capital. For instance, if it costs Jason $400,000 to build a new gum store and the store earns $100,000 in its first year, then the return on the invested capital is 25%.

As for identifying bargains, Greenblatt says to find those with the highest earnings yields. Earnings yield is earnings per share divided by the share price, or the inverse of a stock's price-earnings ratio. It essentially represents what a stock would yield if a company paid out all of its earnings as dividends. If Jason's Gum Shops earned $1.20 per share last year and the stock traded at $12, then its earnings yield would be 10%. The higher the yield, the cheaper the stock.

The numbers. Those are the only two variable components in the Magic Formula, but they're not easy numbers for individual investors to find. So Greenblatt developed and financed MagicFormulaInvesting.com, on which Standard & Poor's Compustat, perhaps the most sophisticated financial database around, ranks the 3,500 largest companies traded on U.S. exchanges first for return on capital and then for earnings yield. The two scores are combined, and companies are ranked by their total score.

The two questions you have to answer are how many companies you intend to invest in (25, 50 or 100) and the minimum stock-market value of the companies on the list. Out comes your list of stocks. You invest 20% to 33% of your money in the six to ten highest-ranked stocks every two or three months until you're fully invested, and sell and replace each of them as they reach their one-year holding period.

The companies that showed up recently cannot be easily pigeonholed in a Morningstar style box. "You get all kinds of different things that are out of favor for different reasons," explains Greenblatt. In mid January, if you restricted your choices to bigger companies, you'd have seen the likes of Coach, Harley-Davidson, and publishers McGraw-Hill and Meredith. Open it up to all companies, and microcap stocks, such as Asure Software and mechanical contractor KSW, joined the mix.

Had you followed Greenblatt's instructions religiously between 1988 and 2004 by investing in the 30 highest-ranked stocks among all 3,500, you'd have earned an annualized 31%, or two and a half times what Standard & Poor's 500-stock index returned. Had you confined your investments to the 1,000 largest companies, you'd have earned 23% annualized, twice the index's gain.

Occasional glitches. Astounding, you say? We think so. But Greenblatt, who as a professional investor knows a few things about investor psychology, foresaw a problem for buyers of his book who attempt to follow the Magic Formula plan: It doesn't work all the time. On average, it works seven months out of every 12, and three out of every four calendar years. When Magic Formula investors hit rough spots, what do you think most will do?

Greenblatt replies: "They'll say, 'Why am I following that stupid computer?' That's just human nature." For people who stick with the program for years, that's a good thing. If every investor jumped on the Magic Formula bandwagon, says Greenblatt, it would probably stop working because bargains would quickly disappear. But, he says, most people lose patience. They abandon the Magic Formula and go on to some other strategy or fad, leaving the bargains in place for those who persevere.

This already appears to be happening. The second half of 2007 was rough for newly bought Magic Formula stocks, say members of Yahoo's Magic Formula message board. Some reported double-digit losses. Particularly hard hit were the smaller companies on the list. There's no way of knowing how many people gave up trusting "that stupid computer," but there is abundant evidence that dissatisfied Magic Formula followers are trying to improve on the formula.

Instead of investing in the 25 top-ranked stocks, Kiplinger's subscriber Marty Ams, of Westlake, Ohio, chooses his 25 at random from among the 50 top-ranked companies -- but only if he can find a recommendation for that stock from another source. On Yahoo, certified financial analyst George Peng suggested putting stop-loss orders on Magic Formula stocks to protect against declines. Fellow Yahooer David Williamson advocates doing your own research on each stock the Magic Formula spits out "to see which ones hold up." Ted Wu sells his big winners before a year is up and holds his big losers beyond a year. In early January, easily 90% of the messages on Yahoo's Magic Formula forum dealt with altering the system.

Uncertainty rules. Greenblatt seems resigned to the head games and second-guessing. He knew it would happen. "If you knew enough about each of the stocks that come up," he says, "you probably wouldn't buy them -- after all, they're out of favor." Adds Greenblatt: "A lot of them will lose you money. But a lot of them will make you money and, going in, you don't know which is which."

Greenblatt acknowledges, however, that if you don't like a stock on the list, some picking and choosing probably won't affect your return much over the long term. Still, all the head games over the Magic Formula leave you wondering why people just can't seem to leave well enough alone. What's so bad about investing in the top-ranked stocks, no questions asked, and getting on with your life until it's time to pick again? The answer: Nothing.