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The Joel Greenblatt Way : Grow Rich "Not Trying Very Hard"

April 09, 2006

By Brian Zen, SuperinvestorDigest.com

Would you like to earn 30% a year and turn $11,000 into $1 million in 17 years while "not trying very hard"?

If you would, I urge you to start by making a mere $20 purchase of "The Little Book That Beats The Market" by Joel Greenblatt. In the book, you will find a "magic formula" and the operating steps towards your millions.

The beauty of the magic formula is that it can be summarized in one sentence. Are you ready?

The Formula Is Simple

The magic formula says: Stick to buying "good" companies (those with a high return on tangible capital) at "cheap" prices (when you can get a high earnings yield).

That's it! The keyword here is "stick to". Based on an extensive study by Greenblatt, a dummy computer, armed with the magic formula, can more than double the market's average annual return, with very low risk and volatility. And the best of all is that it can be accomplished by "not trying very hard", as Greenblatt says, if you use his website: magicformulainvesting.com to pick what to buy. As to when to sell, the harder half of the investing game, Greenblatt suggested a one-year holding period as a mechanical selling rule. The idea is to remove the uncertainties and difficulties involved with selling. "I am terrible at selling myself," reflected Greenblatt, "For the formula, both the one-year and the two-year holding periods worked quite well. I picked the one year period. I call it the 'Not-Trying-Very-Hard' Model. (Audience laughed.) My mantra is to keep things simple."

The magic formula elegantly captured the essence of value investing with an astounding back-tested performance record, which is drawing huge crowds into bookstores all over the country. Even Warren Buffett joined the party recently to congratulate Greenblatt on his work. "Terrific book," Buffett said, "Buying great businesses at cheap prices. Doesn't it seem so simple?"

Simple? Yes. Easy? No. Imagine a group of smokers gathering around a Zen Master trying to learn the oriental secrets of inner peace and longevity. The Master said, "By simply following my teaching, I can add 10 years to your life span with a guarantee!" The smokers opened their eyes to the size of quarter dollar coins. The Master said, "I distilled my formula into two words. Are you listening? Two words: Stop smoking!" Immediately, the gleam in the smokers' eyes started to fade away.

The magic formula for wealth is just like the magic formula for health above, "simple but not easy," as Warren Buffett puts it.

The Execution Is Hard

Here comes the bad news. It is difficult for emotional human beings to execute a strict formula with patience and persistence. In a recent talk at a New York Barnes & Noble bookstore, Joel Greenblatt warned a crowd of about 300 fans seeking his autograph, "The magic formula is not that magic because it can underperform for a number of years in a row. Most people quit something that doesn't work for one or two years. It is tough to stick with a formula. And even if you would stick with it, you customers won't, especially after it failed to work for two years. Not many professionals and individuals can pull it off."

Yes, the results of the formula are amazing over a long period of time. But...there are still 1, 2 and even 3 year periods when the formula doesn't work at all! Most people just don't have the patience or the discipline to stick to it through the tough periods. And for those who do, the reward over the long term could be substantial.

Why Disclose The Secrets?

"Why disclose your internal secret formula that worked so well? Will it continue to work after the book hits the best-selling list?" an investor asked.

Joel Greenblatt answered he is not worried at all that, if the secret is disclosed, it would lose the magic. In fact, he is still making a good living using the strategies discussed in his first book, "You Can Be A Stock Market Genius". Besides, strategies based on ROA, ROE, enterprise value, and low P/E have already been out there for centuries. Yet they continue to work well. So will the magic formula.

More importantly, to use the magic formula, investors need faith, patience and discipline. In other words, the "real" secret is not in the book itself. The real secret lies in the execution of it. The key question here is: How can an average person successfully execute a simple strategy by cultivating patience and discipline? It is a question that puzzled the oriental Zen Masters for thousands of years. As a hobby, I run research workshops at Zenway.com discussing self-cultivation techniques for investors. I know first hand how hard it is to make patience and discipline as widespread as gambling and day trading.

Cheap Alone Works

Numerous studies in the past proved that buying cheap works. Joel Greenblatt has found the buying the good ones among the cheap is even better. After being Buffettized, Greenblatt now prefers the good over the cheap. But interestingly, a study by DrKW Marcro Research found that cheap alone works just as well. DrKW's study shows that the return on tangible capital (ROTC) measure of goodness seems to bring little to the party in the UK and the USA. In all the regions except Japan, the returns are higher by simply using a pure earnings yield (EY) filter instead of a combined ranking of cheapness and goodness. In general, DrKW finds that it pays to buy on the cheap. Just as Greenblatt pointed out, the good old low P/E strategy continues to work after the secret was disclosed a long time ago.

While return on tangible capital (ROTC) didn't seem to add much value to performance when the cheapness was ranked using EBIT/EV, the return on assets (ROA) measure of goodness did add a lot when the earnings yield (EY=E/P) was used as a ranking of cheapness. The DrKW study added credibility to Greenblatt's finding that EBIT/EV is a better measure than E/P.

In fact, Benjamin Graham's classic cigar butt strategy places less emphasis on the measures of goodness and quality. Let's face it, finding a good company on the cheap is not easy these days after the run away success of the Warren Buffett way. So superinvestors like Eddie Lampert switched to a strategy to buy a bad business (Kmart) at a dirt cheap price and get involved personally.

Cheap And Good Works Better

On the other hand, DrKW study confirmed Greenblatt's finding that the ROTC measure of goodness prevented the massive underperformance that occurred with the pure cheap strategy and reduced portfolio volatility to a certain extent.

In his book, Greenblatt suggests that a strategy using a standard earnings yield (E/P) and return on assets (ROA) should give results that closely mimic those of his own preferred formula. DrKW's study has found that, in general, the E/P and ROA strategy works with only slightly lower returns than the magic formula. This confirms that cheap and good is quite robust for the long term.

In his talk at Barnes & Noble, Joel Greenblatt mentioned that return on equity (ROE) and return on assets (ROA) also worked very well based on his study. But he thinks return on tangible capital employed is the best measure of goodness, which is confirmed by the DrKW study.

The bottom line is, if you buy good companies, good things tend happen more frequently.

You Don't Need Spreadsheets To Make Money

When I asked him about whether he uses spreadsheet models to value businesses. Mr. Greenblatt answered, "I really don't know how to build spreadsheet models. But the good news is that you don't need spreadsheets to make money." This echoes what Warren Buffett says that you don't even need a calculator to value a business. To Joel Greenblatt, using valuation spreadsheets might mean something on the border of "trying too hard".

I also asked Mr. Greenblatt about his filing practices. He said: "I don't keep a specific filling system for the stocks I follow. But analysts at Gotham Capital do."
Unlike Buffett who keeps physical copies of annual reports of the companies he tracks, Greenblatt doesn't keep the old annual reports.

"The most important thing is to know the value of a business and buy a lot cheaper," said Greenblatt. It seems there are many ways to value a business. Greenblatt seems to be waiting for something to hit him hard as a real bargain rather than keeping precise paper trails of valuation numbers.

Among all the various types of superinvestors around the world, there are those who focus on what is simple and basic. With great admiration, I call them the Zenway Superinvestors who stick to simple and ancient mental math and apply common sense with basic Zen principles of focus, patience and self discipline, wasting the least amount of energy and motion in nonessential activities.

Would Institutions Use The Formula?

Some suspect that the magic formula may not tango with the money management institutions. If you are a client of a hedge fund, would you be willing to pay an annual management fee of 2% on your assets plus 25% of the return to hire a hedge fund manager hitting a few computer buttons all day long following a simple formula without doing much independent thinking? This reason alone would probably prevent a widespread adoption of the magic formula investing by large institutions. How can the institutional money managers afford to let you know that they are using a dummy computer to run your money?

In response to a question about whether Gotham Capital plans to launch a mutual fund employing the magic formula, Joel Greenblatt answered: "If the magic formula fund is from me, not at the moment. If it is from someone else, I am not aware of it."

Joel Greenblatt further commented, "The Little Book was written for people who don't know how to value a business. In that regard, a good analyst can add value to the formula."

Superinvestor Digest (SiD) is a research-driven newsletter focused on generating and recognizing the best ideas from the best investors around the world. Unlike interview-driven newsletters, SiD works to distill and synthesize the vast library of value investing into a set of practices, processes, and frameworks that are easier to implement. By cutting out the fat, SiD lays out the best of the best in practical investment analysis to save valuable time for the future generations of superinvestors. For more information, please visit: http://www.SuperinvestorDigest.com



Rating: 2.8/5 (22 votes)


Mbfenner - 9 years ago    Report SPAM
His book was horrible. He didn't mention any companies he had purchased with his system so the reader has no way to know if it really worked or not.
Buffetteer17 premium member - 9 years ago
Not a valid criticism. To use his system, you would own several dozen companies and have high turnover for several years. The list of companies would therefore be in the hundreds. Which ones did well would be a statical accident.

As he said in the book, the Magic Formula selects portfolios, not stocks.

I personally don't use the system and have little interest in it, because I do know how to value a business. I think I can do better than the Magic Formula. However I do periodically scan the Magic Formula list of stocks for ideas for further research.
Buffetteer17 premium member - 9 years ago
A little off topic:

"The Master said, "By simply following my teaching, I can add 10 years to your life span with a guarantee!"

My response would be to dismiss the Zen Master as a charlaton. Checking the CDC figures [http://www.cdc.gov/MMWR/preview/mmwrhtml/mm5114a2.htm] for smoking mortality, I find that the average years of life lost per person in the USA due to smoking is about 0.025. That is to say, 9 days. Of course, most people don't smoke, currently about 21% of the population are smokers. If we apply the CDC figure for years of life lost to just smokers, the number is much worse, about 45 days.

Smoking of course is not good for you. As a smoker, besides, losing 45 days of life, you can expect to be sick a lot more, and spend about 2 years of your life more than non smokers with severe disability. But the public perception of the harm from smoking is greatly exaggerated.
Augustabound - 9 years ago    Report SPAM
Congratulations on quitting. I've never smoked but had a close friend who did. Like most he tried to quit multiple times, then he finally had enough and had to make the same choice you did at the same age. He's been smoke free for 2 year.
Kprasad - 9 years ago    Report SPAM
Mbfenner - I guess most people take Greenblatt's word for it. Unless of course you think he's the kind of guy who is just trying to make a quick buck selling this book.

As a side note, smoking will kill your quality of life long before it kills you.
Batbeer2 premium member - 9 years ago
Some say you will live longer by not smoking, drinking and f*ing. That may or may not be true but one thing is for

sure... Your life will certainly seem a lot longer.

If too much of something is not good, it's not necesarilly a bad thing.
Sabonis premium member - 9 years ago
When I was 10 years old my father caught me smoking a cigarette.

As punishment he made me smoke a whole pack.

I have been hooked on cigarettes ever since.

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