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Could Investors Use a Little Magic?

How Joel Greenblatt's magic formula stacks up against some popular mutual funds.

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One of the classic debates in investing is indexing versus active management. The data is clear that few active mutual fund managers are able to beat broad market indexes such as the S&P 500 Index over extended periods. Still, there are some managers who have shown the ability to beat most broad indexes over long periods of time, including those we've named Fund Managers of the Year in past years and those we've recently named Fund Managers of the Decade.

In this piece, I'll approach this classic debate from a different angle. Is there a seemingly ridiculously simple, mechanical, quantitative formula that can beat not only the index but also top-performing actively managed mutual funds that Morningstar has praised over the years and that have themselves beaten the index? Evidence is emerging that there may be at least one.

Graham's Formula
Late in his life, long after he had written the first editions of his two investing classics Security Analysis and The Intelligent Investor, Benjamin Graham gave an interview, reprinted in a book called The Rediscovered Benjamin Graham by Janet Lowe, in which he presented the principles of a simple formula that most investors, including amateurs, could follow relatively easily. This formula had two components or what quantitative analysts these days would call "factors." They were a price/earnings ratio of 7 or less and an equity/assets ratio of 50% or higher. Graham argued that picking a basket of 30 or so stocks that met those two criteria and replacing each stock with another one meeting those criteria--either after the original stock posted a 50% gain or failed to do so after two or three years--would yield very satisfactory results. Graham also allowed for the relaxation of the first criterion in an environment of very low interest rates (such as we are in now), when he said a maximum P/E ratio of 10 was acceptable.

John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.