Magic Formula Investing

Great companies at discount prices -- can you imagine a better recipe for investment success? I can't, which is why I called your attention a year ago to Joel Greenblatt's The Little Book That Beats the Market (Wiley, $20). Well, guess what? Since I wrote about The Little Book last March, Greenblatt's formula has laid an egg. Does it need fixing?

Two numbers

The Little Book argues that if you know a mere two numbers, you can identify those great companies selling at discount prices. The first is return on capital, because a company that can reinvest its profits at a high rate of return will become a very successful business. The second is earnings yield, or earnings per share divided by the share price. The higher the earnings yield, the more bargain-priced the stock.

To make it easy for everyone to find great buys by the numbers, Greenblatt maintains Magicformulainvesting.com, where you can order up (free, so far) your own list of candidate stocks that score best by the two criteria. Another Web site, FolioFn.com, lets you create your own portfolio of dozens of stocks and add to them regularly, in small amounts, for $199 a year. Could investing get more convenient than this?

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Early in the new year I get an e-mail from Bruce Paton, an avid Kiplinger's reader. He read my column last year, and on April 1 he logged the names of 25 stocks generated by Magicformulainvesting.com. In the ensuing eight months, Paton reports, one company in the portfolio was taken over, and the remainder gained 5%, compared with 11% for Standard Poor's 500-stock index. (Including the taken-over stock would have raised the return to 7.7%.) What gives with the magic formula? Paton asks.

I forward his note to Greenblatt, and the response I get from Joel is pretty much what I expected. In his book, Greenblatt makes it exceedingly clear that from year to year, the returns on a basket of stocks identified by high return on capital and high earnings yield move around a lot. For example, a typical magic-formula portfolio whipped the SP 500 by 20 percentage points in 2005. But last year, the results went the other way. In fact, over periods of several years, the magic formula may not beat the market.

Greenblatt's reply to me takes note of these facts, and adds, "The essential point of the book is that buying above-average companies at below-average prices makes sense and should work over the long term; this certainly proved to be the case over the past 18 years." One fear about any investment method is that if everyone follows it, nobody will benefit. So Joel goes on to say: "The formula should continue to work precisely because almost all investors abandon or will not follow a strategy that has not performed well over the recent past." This is good news for those who stick it out, Joel concludes.

Stocks for 2007

And that's my advice to you: With any investment method that makes inherent sense, stick it out and don't get hung up on short-term trends. The latest magic-formula list of 25 stocks with a market capitalization of $1 billion or more contains names both familiar (Motorola, Palm) and obscure (CGI Group, K-Swiss). Opportunity knocks for those smart enough to realize it.