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Greenblatt on His Strategy: It's All about Discipline

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Often times, investors get the idea that beating the market requires complicated strategies, whether in the form of complex mathematical formulas or highly technical timing mechanisms. Others assume that an investor needs to have some sort of specialized, inside knowledge or God-given natural ability to produce strong returns over the long run.

In 2005, however, Joel Greenblatt showed the investment world that all of those assumptions are wrong. In his Little Book that Beats the Market, Greenblatt laid out a two-variable, purely quantitative strategy that left the market in the dust over the long haul. According to his back-testing, the “magic formula” returned almost 31% annually from 1988 through 2004, a period in which the S&P 500 returned 12.4% per year. (As you’ll see below, my Greenblatt-based Guru Strategy has more recently produced similar outperformance.)

This week, Greenblatt gave a rare interview, telling CNBC that his strategy is “really basic value investing, with a little Buffett twist.” While he dubbed this approach the “magic” formula, it is really grounded more in good old common sense than it is in the supernatural. One of its two variables, return on capital, identifies good, solid businesses that are using what they own to produce high profits. The other, earnings yield (which is similar to the inverse of the price/earnings ratio), makes sure you’re getting those companies’ stocks at good prices. And that’s it — strong companies at good prices.

Ironically, Greenblatt told CNBC, the “magic formula” works over the long haul precisely because it doesn’t always work. “The great thing about this formula is it’s not that great [that it works all the time], meaning there are periods of time — could be two or three years sometimes, sometimes longer — where it underperforms the market,” he said. “And people usually give up on a formula that underperforms the market for that period of time.”

Why is that a great thing? Well, if everybody stuck to the formula, Greenblatt says, the prices of those good companies the strategy identifies wouldn’t get to bargain levels. But since many bail on the strategy when it has an off year or two, disciplined investors are able to scoop up the bargains they’ve left behind. They can get stocks of those excellent companies at steep discounts by staying unemotional and disciplined, and sticking to their strategy. Those who don’t will often miss out on the bargains — and the excellent returns to which they often lead.

The magic formula approach continues to work today, which you can see by looking at the Guru Strategy I created based on Greenblatt’s book. Since I started tracking it in late 2005, a 10-stock portfolio picked using the model has produced average annual returns of 10.5% — and that’s in a period in which the S&P 500 has lost 3.8% per year. The portfolio held up much better than the market in the horrific 2008 year, losing 26.3% vs. the S&P’s 38.5% loss. And this year it’s been red hot, gaining 65%, more than tripling the S&P’s gains.

Greenblatt’s portfolio management style appears to be a bit different than mine. He told CNBC that he buys a portfolio of between 20 and 30 securities, holding individual stocks for about a year. I rebalance my portfolio every month (as I do with all my portfolios, having found that to produce the best results), and keep it more focused, at 10 stocks. Here’s a look at my Greenblatt-inspired portfolio’s current holdings:

                                Validea Greenblatt-Based 10-Stock Portfolio