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August, 2006


Yes, according to The Little Book That Beats the Market, by Joel Greenblatt, whose stunningly better returns than the major market averages may be hard to believe from such an easy system. Indeed, investors' common sense notions of how they should and should not invest may be the biggest hurdle in the way of their taking full advantage of the straightforward approach suggested by the author.

To make it even easier to be a stock market "genius," he has provided a so far still free web site, "Magic Formula Investing," where (after logging in) anyone who wishes may see the latest "magic formula" top picks. Mr. Greenblatt's technique focuses on two things: pre-tax earnings yield and pre-tax return on capital. He recommends buying the 25 stocks with combined top scores on those criteria, then holding them a year. It's almost as simple as that. (He finesses it a little, for tax purposes, tending to sell the losers one trading day before the end of the year and holding the winners for one trading day longer than a year.)

His mean results have certainly been superior by most any definition, in the neighborhood of 30% or better annualized, better than double the performance of the averages.

Are there possible catches to Mr. Greenblatt's hocus pocus? Perhaps. It is not always simple for the typical investor to calculate pre-tax earnings yield or return on capital. Although the author explains in the book in clear terms just what he means by both, sifting through thousands of stocks for the best combination of those characteristics can be cumbersome for those not skilled in setting up stock screening filters. And at some point (likely sooner rather than later) it would seem plausible that Mr. Greenblatt will begin charging (a tidy sum?) for his own pre-screened stock listings.

In addition, most investors have little stomach for severe market downturns and for seeing the values of their equities plummet. But the "Magic Formula Investing" stocks tend to go down quite sharply about every third year, on average, frequently falling even more than the market in general. Thus, on a risk-adjusted basis, some investors may feel it is better to go with another approach. There also, unfortunately, needs to be the usual caveat that "past performance is no guarantee of future returns."

But the misgivings of a majority of investors may be just perfect for those who decide to stick with "Magic Formula Investing" and the excellent total returns it eventually seems to provide for the courageous. After all, if everyone liked Greenblatt's system, it probably would not work. It takes advantage of the fact that people drive down the prices of good stocks too far, when there is a little bad news, and then drive them up too far again, when the news turns brighter. That can result in a sickening roller coaster ride for a nervous investor, but a potentially thrilling experience for the patient one.

For those interested in Greenblatt's approach but put off a bit by the high volatility, I would recommend devouring his book, using his web site, gradually buying the top 25 stocks that meet his guidelines, and keeping about one-third of one's investment dollars in money market funds or short-term bond funds, then rebalancing if or when the equities have risen or fallen substantially. This will lower one's overall return but also smooth it out, so that the total portfolio's dips are not nearly as steep.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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