Advice for Investors

Read it & reap

*Joel Greenblatt’s best-selling investment strategy book offers terrific financial benefits for budding stock-market gurus.

words by > Ken Schachter

Slender, with trim, swept-back black hair, Joel Greenblatt hardly looks the part of the stereotypical blustery, testosterone-addled hedge-fund manager. At fi rst blush, the soft -spoken Greenblatt seems a touch professorial, befi tting his part-time role teaching value and special-situation investing to Columbia University graduate students. Yet, as founder of Gotham Capital, the money manager invests millions of dollars from offi ces overlooking New York’s swanky Madison Avenue. And within that high-octane world, his fi rm has made a habit of outmuscling competitors, averaging annualized returns of 40% for more than two decades.

Still, even with that gaudy fi nancial résumé, Greenblatt rated little more than a footnote in the annals of Wall Street. Th at is, until he wrote the book.

His slim volume, Th e Little Book Th at Beats the Market, about the size of a DVD case, off ers a value-investing strategy that Greenblatt says easily outdistances Wall Street’s professional money managers, who frequently fall short of their benchmarks. Researchers who champion the effi cient-market theory have concluded that trying to beat the averages—commonly the Standard & Poor’s 500—is a losing proposition. Don’t waste your time trying to beat the market, they say. Th e best strategy, many conclude, is simply to ride the wave by investing in low-cost index funds. Rather than try to best a benchmark, those funds merely seek to match them by buying a representative sample of the stocks within the index.

The Little Book, meanwhile, counters that beating the averages is within reach not only of professional investors, but rank amateurs, and that all it takes is sitting down with a book that can be read in the time it takes to watch a football game on TV. Th e main character is a sixth-grader named Jason (Greenblatt insists Jason is real).

An entrepreneurial sort, Jason begins by selling gum to his classmates. Th e book then looks at how to value Jason’s business as he grows it into a chain—Jason’s Gum Shops. Also making a guest appearance is the schizophrenic Mr. Market, borrowed from the writing of value-investing legend Benjamin Graham. Th e 155-page book, written at a middle-school level, off ers to turn virtually any Joe or Jill investor into a micro-Warren Buff ett who can beat the pants off the highly compensated denizens of Wall Street.

Talk is cheap, of course, especially on Wall Street. Where is Greenblatt’s proof? He back-tested his “magic-formula” strategy and found it produced an average return of 30.8% from 1988 through 2004. Th at compares to 12.4% for the S&P 500, with only three years in which the “magic formula” results slipped below the benchmark.

How does it work? At root, Greenblatt sees himself as a business analyst who knows how to pan for companies selling for a fraction of their intrinsic worth. “I call that value investing,” he says. “If a company is growing its earnings, it’s worth more than a company that’s not growing its earnings. If a company is growing slowly, that’s fi ne, as long as I can buy it at a big discount to what it’s worth.”

Th e “magic formula” outlined in Th e Little Book calls for screening for companies with a high pretax earnings yield (which makes them cheap) and a high return on invested capital (which makes them good businesses). For instance, if Jason is able to build one of his gum shops for $400,000 and earn $200,000 a year, that store will have a whopping 50% return on capital. Th e earnings yield, meanwhile, is a value yardstick, indicating the amount of earnings an investor buys for every dollar worth of stock.

In the book, Greenblatt explains how investors can screen for stocks on their own; he also launched a companion site, www.magicformulainvesting.com.

The website—free for now—lets investors type in a market capitalization and get a list of companies that currently pass the “magic formula” screening process.

Won’t a horde of value investors make it harder to fi nd cheap stocks? Greenblatt says he expects little impact on Gotham. “Th e few people who read my book aren’t going to drive the prices on multibillion-dollar companies,” he says. Although his fi rm runs similar screens, Greenblatt says it goes into greater depth in trying to value a potential investment. “I wrote this book for individuals who are not experienced stock-market investors,” he says. “When we invest, we use the principles in the book, except we use our projections three or four years out of what we consider normal earnings.”

Not surprisingly, some on Wall Street are less than thrilled with Greenblatt’s book. An article in Barron’s, titled “Th e Little Book’s Little Flaw,” sought to fi nd fault in his back-testing method. Quantitative analysts discovered that his results came up with returns of 28%—still far exceeding the market’s returns—rather than the 30.8% Greenblatt trumpets. Another fi nancial researcher tried the formula on the largest 1,000 US stocks from 1996 to 2002. While Th e Little Book reported average returns of 16.4%, the researcher, using a diff erent database, found the strategy returned 10%, again beating the S&P 500’s 4%. Meanwhile, Greenblatt retorted that the researcher’s database did not exclude companies’ onetime gains. “Th e database he used to emulate the formula was corrupted and not cleaned out the way the database I used was,” he says. “Th at would explain any disparities.”

Still, The Little Book hovered on the business best-seller lists of both Th e Wall Street Journal and BusinessWeek for months. A fellow hedge-fund manager, Jeff Matthews of RAM Partners, called the book “a terrifi c piece of advice” that focuses on a key tenet of investing: “Good businesses that generate above-average returns make good long-term investments if you buy them at a reasonable price.”

If roiling Wall Street were not enough, Greenblatt is taking on the education establishment in his spare time, pouring $1,000 per student per year into PS 65Q in Ozone Park, Queens, to raise students’ reading skills through a curriculum called Success for All.

And as a follow-up to Th e Little Book, Greenblatt is planning a new book designed to strip the mystery from economics. It will “explain economics in a very simple way,” he says. Jason, meet the laws of supply and demand.