"Magic Formula Investing" Conjures Up 4 New Stock Funds

About five years ago, Joel Greenblatt, who had produced eye-popping returns while managing a hedge fund, wrote one of those mini books entitled The Little Book That Beats the Market.

The book did well for its publisher, John Wiley & Sons, and pretty soon Greenblatt had a free web site, www.magicformulainvesting.com, that allows anyone to screen for stocks that meet Greenblatt’s criteria. The Web site generates intriguing stock ideas, but if you want to buy any of the names it generates, I’d counsel doing additional research before acting.

Now the book that morphed into a web site has birthed four mutual funds, two domestic and two foreign. Each fund invests in stocks and hopes to beat its relevant market using Greenblatt’s formula.

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Greenblatt’s record is worth boasting about. According to Greenblatt’s book, his investment firm produced annualized returns of more than 40% over a period of more than 20 years. Those numbers are off-the-charts spectacular.

Even Greenblatt, 53, doesn’t expect those kinds of returns from his funds. Most of the outsize returns were produced with concentrated portfolios of six to eight stocks. That’s unworkable in a mutual fund and leads to far more volatility than most individual investors can handle. Even the book suggests that investors’ portfolios contain about 30 stocks.

Back-tested results for Greenblatt’s investment strategy are also encouraging. Over the ten years that ended September 30, 2009, the last period for which returns were available, formula investing would have returned an annualized 14.5%. Not bad during a period when returns for the broad U.S. stock market were flat. Of course, back testing is rife with problems. No one would argue that you can predict future returns based on what a given investment method would have done in the past. Still, it’s heartening.

Greenblatt’s new funds will contain far more than 30 stocks apiece. Formula Investing U.S. Value Select (symbol FNSAX) and Formula Investing International Value Select (FNAAX) each invest in about 100 stocks. The other two funds -- Formula Investing U.S. Value 1000 (FVVAX) and Formula Investing International Value 400 (FNVAX) -- invest in as many stocks as their names suggest. Expenses are 1.25% annually for the domestic funds and 1.35% for the international funds.

The formula itself is pretty simple -- or at least Greenblatt made it simple to squeeze it into his mini book. I’m omitting some of the details, but essentially he argues for investing in stocks with high returns on capital and low price-earnings ratios. Return on capital measures a company’s after-tax operating profits by the amount of capital -- both equity and debt -- invested in a company. Return on capital is a good measure of a firm’s profitability. Price-earnings ratio is, of course, a company’s share price divided by earnings per share, in this case earnings over the previous 12 months.

Greenblatt employs eight analysts and plans to hire two more, mainly to analyze each company’s numbers to get clean, comparable data. “The principles behind the mutual funds are very similar to what I wrote about in the book,” he says. “We’re looking for good companies at cheap prices.”

At the end of the day, though, these are largely quantitative funds. In other words, Greenblatt and his analysts don’t plan to visit a lot of executives or spend hours on the phone researching companies. Instead, they’re picking stocks by the numbers -- in this instance, they hope, a magic formula.

I wouldn’t want to bet against Greenblatt. He knows a lot more about stock investing than I do. But I also wouldn’t jump into his funds. I’d give them time -- and examine the results in a year or two to see if Greenblatt really does have a magic formula.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C., area.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.