What a lot of investors don’t realize is that while investing is difficult, it doesn’t have to be complicated, and Joel Greenblatt has proved that, writes John Reese of the Validea Hot List.

Back in 2005, Joel Greenblatt created a stir in the investment world with the publication of The Little Book That Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula"—a purely quantitative approach with just two variables: return on capital and earnings yield.

Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8% return from 1988 through 2004, more than doubling the S&P 500’s 12.4% return during that period.

Greenblatt also posted impressive numbers in his money-management experience, with his hedge fund, Gotham Capital, producing returns of 40% per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt’s "Little Book"—it’s only 176 pages long and small enough to fit in your jacket pocket—broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves.

Using several simple analogies, he explains a variety of stock-market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son, who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices—something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did.

The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task—buying those good companies’ stocks on the cheap.

The earnings yield is similar to the inverse of the price-to-earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being No. 1, the second No. 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense—and are particularly interesting given the recent credit crisis.

For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn’t use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company’s stock, but instead by enterprise value—which includes not only the total price of the firm’s stock, but also its debt. This gives the investor an idea of what kind of yield they could expect if buying the entire firm—including both its assets and its debts.

In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks producing a good earnings yield that isn’t contingent on a high debt load.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past four years or so.

So far, the model has been an exceptional performer. Since we began tracking our ten-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 4.8%; the Greenblatt-based portfolio has gained about 80%—that’s 11% per year.

The Greenblatt portfolio also did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in ’08—not good, but much better than the S&P 500’s 38.5% loss—and surged 63.1% in 2009, vs. 23.5% for the S&P.

Greenblatt stresses that the strategy won’t beat the market every month or even every year, however, which is important to remember. Over the long haul, though, it should produce excellent returns.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.

Here are four of my favorite Greenblatt-based picks:

  • Bridgepoint Education Inc (BPI)
  • Lincoln Educational Services Corporation (LINC)
  • LHC Group (LHCG)
  • Oshkosh Corporation (OSK)

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