6 Stocks from a Quant Master's Strategy

By MoneyShow.com | April 17, 2012 AAA

Joel Greenblatt made quantitive investing accessible for individual investors, and his simplified system is still effective, writes John Reese of Validea Hot List.

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks—Joel Greenblatt has proved that.

Back in 2005, 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 had just two variables: return on capital and earnings yield.

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 give 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 that are producing a good earnings yield that isn't contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book. We added the Greenblatt portfolio to our site in January 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 a strong performer, with some big ups and downs. Since we began tracking our ten-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 11.1%; the Greenblatt-based portfolio has gained about 46%—that's 6.2% annualized, vs. 1.7% annualized for the S&P.

The portfolio beat the market in 2006 and 2007, and then 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 2008—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.

It beat the market slightly in 2010, had a rough 2011 (losing 15.3%), and has lagged so far this year. 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's a look at some of the current holdings of my Greenblatt-based portfolio. Among the holdings are four firms from the much-maligned for-profit education industry, a sign of how the strategy isn't afraid to head into rough waters to find bargains:

  • Bridgepoint Education Inc. (BPI)
  • Apollo Group Inc. (APOL)
  • ITT Educational Services (ESI)
  • GT Advanced Technologies Inc. (GTAT)
  • Strayer Education Inc. (STRA)
  • C&J Energy Services Inc. (CJES)

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