Greenblatt's Magic Formula for Investing

Successful hedge fund manager Joel Greenblatt's latest book, "The Little Book that Beats the Market," focuses on finding good businesses and paying reasonable prices to own them. This is not a new concept, and Greenblatt's "magic formula" for beating the market is based on two simple ideas. First, Greenblatt advises investors to buy companies with high returns on capital, suggesting a company is a good business. (Click here for an in-depth article by Morningstar stock analyst Elizabeth Collins on this measure.) Second, Greenblatt advises investors to focus on companies with high earnings yields. A high earnings yield is just another way of saying that a company's shares are selling cheaply relative to its earnings. Still, Greenblatt's message is one that fund investors would do well to heed.

The Business Approach to Investing
What makes Greenblatt's message valuable is its focus on investing as opposed to speculating. Investing involves risk, but it is not buying something with the hope that you'll be able to sell it to someone else for a greater price later. Investing is financing the operations of a business, and it involves trying to understand if that business is healthy enough and profitable enough to give you an adequate return on your capital from its operations, based on the price you've paid for your interest in those operations. This is what Warren Buffett has called a "business" approach to investing, and it's the one we favor at Morningstar both when we analyze stocks and when we evaluate the investment processes of mutual fund managers. Our stock analysts prefer free cash flow yield instead of earnings, as they believe free cash flow is a more accurate measure of the amount of cash that can be lifted out of a business without disturbing its operations. They also use something called a discounted cash flow analysis to value the stocks they cover, but the principles are the same as Greenblatt's.

A Look at Fund Management
Similarly, my fellow mutual fund analysts and I also tend to prefer managers who employ some variation of this "business" approach. For example, we excused a lot of funds we like for underperforming in 2003, when lower-quality companies surged. Also we've been leery of funds that outperformed in 2005 because they loaded up on oil stocks, whose returns on capital are driven by the price of the commodity they sell and are, therefore, out of their control. Even if you invest exclusively in mutual funds and never look at the annual reports of individual businesses, we think it's important to remind yourself to view investing in this way. Doing so might well keep you from making the mistake of chasing hot-performing investments at precisely the wrong time. Additionally, you can benefit from this approach by applying it to your fund managers and judging them against it. By doing so, you can better understand why they might be faltering during a particular period of time, because, as Greenblatt says, the high earnings yield, high return on capital approach doesn't win every year.

Patience Is a Virtue
If buying good businesses at reasonable prices hasn't even worked in every year that Greenblatt backtested, will it work in the future, and will it give you a reasonable basis on which to judge your fund managers? Yes and no. In any given year the formula won't work because so many short-term minded investors won't have the patience to stick with the strategy. But for fund managers who are adept at executing their strategy, such periods can provide an opportunity to buy good businesses cheaply, which should help fuel strong long-term performance. Consequently, fund investors frustrated by poor performance should ask whether their funds are employing a style that cannot achieve repeatable success over the longer haul, or whether it is a temporary period when buying good businesses at reasonable prices isn't working. Our fund analyses are always sensitive to those issues and help investors "get beyond the numbers" in that sense.

There is one aspect of Greenblatt's strategy that we disagree with. He wants investors to purchase the top 30 or so stocks that are at the top of the list for earnings yield and return on capital, but he also wants investors to sell them after a year and purchase the new stocks that populate that list. Our preference, once we buy great businesses, is to hold them. That's the way we run our equity newsletter portfolios, and that's what we prefer to see in the mutual funds that we cover. Fewer trades reduce or at least defer the tax bill and lead to lower costs. Also, the whole point of looking for superior businesses instead of mediocre ones trading cheaply is that once you can snag a profitable company at a good price, its ability to sustain profits precludes your having to sell it anytime soon.

For more on Greenblatt's strategy, see the January issue of Morningstar GrowthInvestor.