Why Value Investing Is Hard

Successful bargain hunters must brave going against the crowd and, at times, looking foolish.

In The Little Book That Beats the Market, published in 2005, star money manager Joel Greenblatt describes a “magic formula” for success that ranks stocks based on only two factors: share price relative to a firm’s earnings and return on capital. His formula looks for companies with a great combination of quality (reflected by a high return on capital) and a bargain price (reflected by a low price-earnings ratio). Back-tested over the 17 years before the book’s publication, Greenblatt’s formula produced a stunning an­nualized return of 31%, compared with a mere 12% for Standard & Poor’s 500-stock index.

After reading his book, we asked Greenblatt if widespread adoption of his simple plan might undermine its effectiveness. He was unconcerned: “Value investing strategies have worked for years and everyone’s known about them. They continue to work because it’s hard for people to do, for two main reasons. First, the companies that show up on value screens can be scary and not doing so well, so people find them hard to buy. Second, there can be one-, two- or three-year periods when a strategy like this doesn’t work. Most people aren’t capable of sticking it out through that.”

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John Heins
Contributing Editor, Kiplinger's Personal Finance