"Investing is simple, but it's not easy."
-- Warren Buffett, Fortune.com, 2009
Simple and easy: We often use those two words interchangeably,
but they are far from the same. Running a marathon, for example, is
simple. Start running several times a week, build up your
endurance, and then go to the race and just follow the crowd. Not a
lot of steps or complexity in that process.
Of course, if you think that means running a marathon is easy,
you're nuts -- you have to have tremendous discipline and great
time management, and you have to stay healthy and avoid any of a
number of injuries that sideline many runners.
In investing, a great example of the simple-but-not-easy concept
is hedge fund guru Joel Greenblatt. Back in 2005, Greenblatt
published The Little Book that Beats the Market, a small, concise
book that shows how investors can produce market-beating returns
using a formula that has two -- and only two -- variables.
In an investing world of seemingly limitless data points, that
may sound improbable. But it's not. Greenblatt's "magic formula",
as he called it, produced back-tested returns of 30.8% per year
from 1988 through 2004, more than doubling the S&P 500's 12.4%
return during that time. What's more, a 10-stock portfolio picked
using my Greenblatt-inspired Guru Strategy computer model has
averaged an annual return of 10.7% in the four years since its
inception -- while the S&P 500 has gained 5.3% per year. Last
year alone, the portfolio was up 51.4%; this year it's up 10.7% vs.
6.4% for the S&P (through July 11).
How does the Greenblatt approach work? On a broad level, it's
based on a very simple, sensible, Buffett-esque notion of
Greenblatt's: "Buying good companies at bargain prices makes
To identify "good companies", Greenblatt uses the first variable
of his "magic formula": return on capital. Essentially, ROC is a
way to see how much money a company is making by using its assets.
The higher the ROC, the better job the company is doing in terms of
Return on capital is similar, but not identical, to the return
on assets rate that Buffett and other gurus like Peter Lynch use.
Rather than using a company's reported earnings, as is done when
calculating ROA, however, Greenblatt (and the model I base on his
writings) uses earnings before interest and taxes (EBIT), so that
debt payments and taxes don't obscure how well the firm's actual
operating business is doing. And instead of dividing that by total
assets, as ROA does, he divides it by "tangible capital employed,"
which is equal to net working capital plus net fixed assets. "The
idea here," he writes, "was to figure out how much capital is
actually needed to conduct the company's business."
The second part of the Greenblatt approach is finding those good
stocks when they are selling at "bargain prices". To do so,
Greenblatt (and my model) uses earnings yield. Typically, earnings
yield is calculated by dividing a company's trailing 12-month
earnings per share by its current price per share -- essentially
the inverse of the price/earnings ratio. But Greenblatt also makes
some slight adjustments here, so my model does the same. Rather
than earnings, EBIT is used, and rather than price, "enterprise
value" is used. Enterprise value includes not only the price of the
company's shares, but also the amount of debt it uses to generate
My Greenblatt-inspired model ranks all stocks in earnings yield
and return on total capital, and then adds the rankings together to
get the stock's final ranking. The ten stocks with the best
combined rankings make it into my Greenblatt-based portfolio.
Sounds easy, right? Not really -- remember what Buffett says
about "easy" and "simple" being two different things.
The difficulty of the Greenblatt approach comes not in the
logistics or specifics, but instead with mindset. That's because
while the strategy has been proven to work very well over the long
term, it doesn't work all the time. In fact, the magic formula has
had periods of two or even three years when it has lagged the
market, Greenblatt notes -- not unlike just about any good
strategy. When that happens, he says, most investors bail, jumping
on the latest "hot" stocks or strategies -- which usually lands
them overpriced duds.
Their abandonment of the magic formula approach is, however,
what allows you to buy at bargain prices the strong stocks that the
strategy targets -- if, that is, you have the intestinal fortitude
to stick with the strategy through the short-term pain. You also
have to have the stomach to buy the types of beaten down value
stocks it targets -- quite often it keys on companies making
negative headlines because of short term problems or industry
fears. But if the company has strong financials and fundamentals,
which magic formula stocks do, the fears created by the headlines
are usually overblown, letting you get shares of good companies on
If you stay disciplined, you should reap the rewards when Wall
Street realizes it's overlooked these strong companies. Knowing all
of this -- and in particular knowing that you can't predict when
those down periods and bounce-backs will come -- Greenblatt says
it's absolutely critical to stick with the strategy through the
rough times. In the end, his approach, like Buffett's, is really
based on common sense and discipline -- not magic.
Right now, my Greenblatt-based approach is finding a number of
attractive bargains. Here are five that currently rank high on its
Ebix, Inc. (
Atlanta-based Ebix ($480 million market cap) supplies software and
e-commerce solutions to the insurance industry. Shares have
struggled over the past year as growth has slowed, but my
Greenblatt strategy thinks that has made it a great bargain. It has
a 106% ROC and 15.7% earnings yield.
Nu Skin Enterprises, Inc. (
Multi-level marketers like this Utah-based firm ($4.4 billion
market cap), which sells personal care, nutrition, and technology
products, have come under much scrutiny recently, and Nu Skin was
the subject of a Chinese investigation of its business practices
that led to a small fine. The Greenblatt-based model sees all that
as opportunity. It likes the firm's 15.4% earnings yield and 67%
return on capital.
C.R. Bard (
New Jersey-based Bard is a multinational manufacturer of medical
technologies, focusing on the fields of vascular, urology, oncology
and surgical specialty products. Bard ($11 billion market cap) has
a 12.8% earnings yield and a 70% return on capital.
Performant Financial Corporation (
Performant provides technology-enabled recovery and related
analytics services in the United States. The company's services
help identify and recover delinquent or defaulted assets and
improper payments for both government and private clients in a
broad range of markets. Performant gets strong interest from my
Greenblatt model thanks to its 14.1% earnings yield and 88% return
GameStop Corp. (
Shares of this video game retailer have struggled because of fears
that the rise of online gaming will hurt its stores, but the
business is hanging in there. The Greenblatt model likes its 14.8%
earnings yield and 86% return on capital.
I'm long NUS, BCR, EBIX, PFMT, and GME.