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By Ryan Leggio | 04-04-2011 11:09 AM

Greenblatt: Value-Weighted Indexing Just Makes Sense

Buying an index weighted toward stocks that are cheap, not just big, is a smart way for individual investors to beat the markets, says author and investor Joel Greenblatt.

Ryan Leggio: Hi, I'm Ryan Leggio. I'm a mutual fund analyst at Morningstar and with us today is Joel Greenblatt. He is the author of three books and he is here today to talk to us about his latest book, The Big Secret for the Small Investor.

Joel, thanks so much for being with us today.

Joel Greenblatt: My pleasure.

Leggio: Your latest book really is a segue from your second book, The Little Book That Beats the Market. Can you talk a little bit about why you needed to write this book?

Greenblatt: Well, big picture, The Little Book, which I still love very much really describes a strategy that individuals can use to pick stocks for themselves and create their own portfolio. When I wrote it, I obviously didn't even expect it to be as popular as it was and I did receive a lot of demand for people to help them do this because it's very hard to put together a portfolio of 20 or 30 stocks, keep track of them, keep track of your taxes, all these things.

As it turns out, most people actually don't want to do it themselves, it's too involved, it takes too much time and there is a lot of complicated record keeping. So, the biggest request I got after writing the book was, can you please just do this for me. So, through our continuing research, we actually were able to design a strategy that should work very, very well for the small investor and we recently made that available for small investors.

Leggio: Those funds are currently in a domestic and an international format both very diversified. Is that correct?

Greenblatt: Right, we have actually four funds, four mutual funds now. One is more select, one is very, very diversified, it's really an index the way we think about it. Those are both domestic. And then we have a similar setup for an international, where one is more select and one is a much more diversified.

Leggio: The book is specifically about the diversified versions, what you call a value-weighted index fund?

Greenblatt: That's exactly right. It's really just something new that we developed that made total sense to us is incredibly simple when you hear what it is and there's very good reasons why we believe this kind of value-weighted index should work much better than what other people are doing with their money now.

We just took the logic that, if we can buy a stock at a bargain price that we want to own more of that one. So, instead of weighting by market cap or equally weighting or by economic size, we weight by how cheap we can buy a company. So, the bigger bargain that we find, the more we own of it. So, we actually took the largest 1,400 companies listed in the United States, and we put together an index of 800 to 1,000 of those companies. And we didn't equally weight them, we weighted them according to value.

So, we have heavier weights in those stocks that we believe are the cheapest, and we have very simple metrics that we use to decide which are the cheapest stocks and we buy more of those and every day we go out and rebalance the portfolio, so that it's constantly and continually rebalanced towards the cheapest stocks that we can find based on those simple metrics. And over time, over the last 20 years when we tested them doing this kind of thing beat a market cap-weighted index by about 6% a year and it had the same volatility and the same beta as market cap-weighted index, but you've got six extra points which was very exciting to us and it makes total sense to us. Why wouldn't you want to concentrate in the cheapest stocks that you can find?

Leggio: You are basically using the same formula that you outlined, The Little Book That Beats the Market which is earnings yield and returns on invested capital, but instead of investing in just 30 to 50 stocks, you are investing in 800 to a 1,000 stocks?

Greenblatt: Right, we used very similar metrics and the principles are really based on Benjamin Graham and Warren Buffett. Benjamin Graham said, let's buy stocks that are cheap, figure out what it's worth and pay a lot less, very straight forward. Warren Buffett added one twist that probably led him to be one of the richest people in the world. He said, well it's nice to buy cheap, but if I can also buy a good company cheap that's even better.

So, we have a metric in here that we look at is how good is the business and the way we measure that is based on its return on tangible capital. In other words, how well does that business turn its investments in working capital and fixed assets into earnings? The better it does the better business we think it is. So, we basically weight how cheap the company is and how good it is, and we combine that into our value-weighted index.

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