(01/03/14) Magic Formula Portfolio

While making money in stocks is hard, it doesn't have to be complicated; Joel Greenblatt proved that in 2005, when he published The Little Book that Beats the Market, explains John Reese, editor of Validea.

Greenblatt 's book was a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula"—a purely quantitative approach that had just two variables: return on capital and earnings yield.

His back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8% return from 1988 through 2004, more than doubling the S&P 500's (SPX) 12.4% return during that period.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory.

As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices—something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did.

The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital.

The earnings yield variable, meanwhile, accomplishes the second part of the task—buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings, compared to the price of their stock.

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number one, the second, number two, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years. So far, the model has been a strong performer, with some big ups and downs.

Since we began tracking our ten-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 41.7%; the Greenblatt-based portfolio has gained 114.9%—that's 10.0% annualized, versus 4.4% annualized for the S&P (all performance data through December 4).

The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what, for stocks, was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08—not good, but much better than the S&P 500's 38.5% loss—and surged 63.1% in 2009, versus 23.5% for the S&P.

After beating the market again in 2010, it struggled in 2011 and 2012, however. But Greenblatt stresses that the strategy won't beat the market every month, or even every year, which is important to remember.

In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisciplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

Indeed, in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 50%. Below is a look at its current holdings.