The past few weeks have seen Joel Greenblatt, the father of Magic Formula Investing (MFI), out promoting his new book released Tuesday, titled The Big Secret for the Small Investor. MagicDiligence is in the process of reading the book, and a full review should be up as early as next week. From Greenblatt's interview with Morningstar, we already have a pretty good idea of what the book is about and the motivation behind it. The "big secret" is value weighted indexing. Most indexes, like the S&P 500 or Russell 3000, are weighted by market cap. That means that for every dollar you invest in them, the largest cap stocks get more pennies then the smaller cap stocks. For example, if you invest $100 in a S&P 500 index fund (SPY is a popular one), about $3.48 is invested in ExxonMobil (XOM), the largest-cap stock in the index, while about $2.52 is invested in Apple (AAPL), the second largest, and so on.
Greenblatt believes weighing the indexes by value parameters, such as the operating earnings yield and return on tangible capital used by MFI, produces better results. In the Morningstar interview, he says that market cap weighting removes about 2% of annual returns as opposed to equal weighting (where money is spread evenly among all stocks in an index). A quick Google search will net you dozens of studies corroborating that fact, and it makes intuitive sense as well -— very large cap stocks have more limited growth avenues and are more appropriately priced, in general. Continue Reading »