A “magic formula” and dueling philosophies for individual investors

09Nov05

How would you like to have these as blurbs for your investment book ?

"Simply Perfect. One of the most important investment books of the last 50 years"- Michael F. Price

A landmark book – a stunningly simple and low risk way to significantly beat the market"
– Michael Steinhard

If these blurbs were from lesser investment lights, a skeptical investor would run the other way. However, the normally skeptical Jesse Eisenger reviews Joel Greenblatt’s “The Little Book That Beats the Market" and finds a “magic formula" for investing. We cannot remember a book getting a warmer response than that seen in this Wall Street Journal piece.

This is not Greenblatt’s fist book, indeed his first book, “You Can Be a Stock Market Genius : Uncover the Secret Hiding Places of Stock Market Profits" is an excellent primer on a number of off the beaten path strategies. Apparently it has become a hit among hedge fund managers:

"His book on investing is by far the most valuable thing I have read," says David Einhorn, who manages a large, successful hedge fund, Greenlight Capital."

For his second book Greenblatt has written in simple terms about a powerful investment strategy. The notion, whether tongue in cheek or not, that there is a “magic formula�? is a double-edge sword. According to Eisinger:

What is the magic formula? Invest in good companies when they are cheap. As Mr. Greenblatt might say: See? We told you it sounded obvious. Yeah, so what's "good"? And what's "cheap"?

Good companies earn high returns on their investments, he explains, while cheap companies sport share prices that are low (based on past earnings). His proxies for these criteria are return on capital (operating profit as a percentage of net working capital and net fixed assets) and earnings yield (pretax operating earnings compared with enterprise value, which is the market value plus the net debt). To his credit, however, Mr. Greenblatt explains all that parenthetical jargon in terms that shouldn't insult his peers but that will ring a bell for the unschooled masses.

To make things simpler still, his free Web site, http://www.magicformulainvesting.com, screens companies using his criteria. He advises individual investors to buy a basket of top stocks and turn them over on a strict schedule, depending on how they perform. (For maximum tax advantage, sell losers just before a year's up, and winners just after a year.)

It sounds too easy. But in fact, his approach is difficult not because it is hard to understand, but because it requires patience and faith that you are right when the market is saying you're wrong.

Eisinger notes that this system, along with all others, does have its flaws. However for investors willing to spend the time and effort there apparently is a ‘there’ there.

Greenblatt has been incredibly successful running a hedge fund in part according to this Buffett-like approach. Another successful investor with a new book out, David Swensen takes an entirely different approach to providing advice to individual investors. Rather than focusing on individual stocks, Swensen advocates individuals diversify among low cost index funds.

How can two wildly successful investors come to such different conclusions? The Swensen approach is much more of a “do no harm" sort of philosophy. The real-world evidence shows that it is very difficult for amateur and professional investors alike to beat the market. Swensen advocates for individual investors to not even play the game and simply try to match the market. If followed, individuals are unlikely to make a hash out of this strategy.

Whereas the Greenblatt approach is riskier. The Greenblatt approach says that with a well-articulated strategy individual investors can beat the market by actively managing their equity portfolios. The risk is less that the model will stop working (although this is always a risk). The risk is that individual investors are unable to effectively follow the strategy. Every strategy will go through rough times. The question is whether individual investors will be able to effectively implement this type of approach over time.

Avid investors will read both books and decide for themselves. Most investment books geared toward individual investors are not worth the paper they are printed on. Considering the quality of both author’s earlier books, these new books sound like they are worth a read. Investors will have to decide for themselves, which approach (or some combination thereof) best suits their investment needs.