Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joel Greenblatt-inspired strategy, which has averaged annual returns of 6.6% since its December 2005 inception vs. 2.4% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Greenblatt-based investment strategy.

Taken from the February 1, 2013 issue of The Validea Hot List

Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don’t realize is that while it is difficult, it doesn’t have to be complicated. You don’t need incomprehensible, esoteric formulas and you don’t need to spend every waking hour analyzing stocks — Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his “Magic Formula” — a purely quantitative approach had just two variables: return on capital and earnings yield.

Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500’s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt’s “Little Book” — it’s only 176 pages long and small enough to fit in your jacket pocket — broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

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.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, 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.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense — and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn’t use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company’s stock, but instead by enterprise value — which includes not only the total price of the firm’s stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm — including both its assets and its debts. In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn’t contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past five years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 18.8%; the Greenblatt-based portfolio has gained 58.2% — that’s 6.6% annualized, vs. 2.4% annualized for the S&P. 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, vs. 23.5% for the S&P. After beating the market again in 2010, it has struggled the past two years, 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: Undisiplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.

So far in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 10% already. Here’s a look at its current holdings.

USANA Health Sciences Inc. (USNA)

Express Inc. (EXPR)

Strayer Education Inc. (STRA)

C&J Energy Services Inc. (CJES)

CACI International Inc. (CACI)

InterDigital, Inc. (IDCC)

CA, Inc. (CA)

Belo Corp. (BLC)

AmSurg Corp (AMSG)

PDL BioPharma, Inc. (PDLI)