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)

Subscribe to Validea Hot List here...

Related Reading:

3 Screaming Growth Buys

3 Important Tips for Growth Investors

2 Tip-Top Tech Stocks

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  3. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  4. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  5. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  6. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  7. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  8. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  9. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  10. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center