My Guess: Joel Greenblatt Singlehandedly Humbles the Fund Industry

Joel Greenblatt, hedge fund manager and author of the wildly popular book, The Little Book That Beats the Market, has a new project. It's a book called The Big Secret for the Small Investor.

I just ordered my copy. Full disclosure: I haven't read it yet. But a few media interviews and reviews have already laid out the book's fundamentals.

Based on that information, I'd guess that not only will it be a bigger hit than the Little Book, but it will also humble the entire fund industry.

The basis of the Little Book is that lay investors can beat the market simply by buying good companies at good prices. Many investing talking heads have said so over the years. But Greenblatt actually showed you how: Screen for companies with high earnings yield ratios and high returns on capital. Rank them. Buy the top couple of dozen, or even just the ones you liked. Rinse. Repeat. He even set up a website, magicformulainvesting.com, to run the screens.

The simple formula absolutely destroys market averages over time. Greenblatt backs this up with considerable statistical evidence.

The book was beautiful in its simplicity. It didn't require you to be a finance geek to understand it. No spreadsheets. No Greek symbols. No charts. These things lead investors astray as it is. Since the formula preselected for cheap, high-quality companies and advised you to purchase so many of them (at least 20, preferably 30 or more), diversification and a form of margin of safety worked in your favor. While far from perfect or risk-free, it was a smart way for people not looking to get deeply involved in their investments to have a decent shot at outperforming market averages.

But as Greenblatt notes in a recent interview with Morningstar, "As it turns out, most people don't want to do it themselves. It's too involved. It takes too much time. There's a lot of complicated record keeping. So the biggest request I got after writing the book was, 'Can you just please do this for me?'"

So he did.

Greenblatt and his partners formed a family of funds that, more or less, follow the guidelines outlined in the Little Book. You can see them here.

These funds are different than most. Most index funds are weighted by market cap. An index might be comprised of 500 companies, but they're not owned in equal amounts. For example, ExxonMobil (NYSE: XOM  ) has a 3.53% weighting of the S&P 500; Microsoft (Nasdaq: MSFT  ) gets a 2.15% weighting. Bank of America (NYSE: BAC  ) gets a 1.57% weight, and so on. Size, not quality, determines rank.

Not so in Greenblatt's funds. This is where the "secret" in his new book apparently comes in. As his prospectus notes, portfolio holdings will be "weighted by the Advisor's assessment of fundamental value, as opposed to market capitalization." The "assessment," it appears, is based on the method outlined in the Little Book. The cheapest and highest-quality companies determined by a basic formula get the most weight. Easy as that.

This isn't exactly new. Many mutual funds place their biggest bets on their best ideas. But Greenblatt's funds aren't really mutual funds. They're far closer to index funds -- formulaic in nature, rather than actively -- and subjectively -- managed.

That's what's new about Greenblatt's approach -- and why I think he'll end up humbling the fund industry. He's taken what works in mutual funds -- their ability to heavily weight in their best ideas -- and combined it with what works in index funds -- not having to outthink the market, which very few people can do successfully.

Greenblatt notes in an interview that backtesting his fund's methodology over the past 20 years "beat a market cap-weighted index by about 6% a year and it had the same volatility and the same beta as market cap-weighted index." That's huge. If repeatable (never a sure thing), it'd humble the majority of funds in the industry. By a long shot.

Will it succeed in the future? The strategy makes a lot of sense to me.

How about you?

Fool contributor Morgan Housel owns Microsoft and B of A preferred. Microsoft is a Motley Fool Inside Value selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Bank of America, ExxonMobil, and Microsoft. Through a separate Rising Star portfolio, the Fool is also short Bank of America. Alpha Newsletter Account LLC owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 17, 2011, at 9:19 PM, dcfairchild wrote:

    is this an article or an ad?

  • Report this Comment On April 17, 2011, at 9:22 PM, TMFHousel wrote:

    ^ Article. I'm in no way shape or form connected to Greenblatt or his companies.

  • Report this Comment On April 19, 2011, at 3:19 PM, mclaugph wrote:

    Consider me skeptical. Once upon a time the "Foolish Four" was a backtested 'simple way' to make money investing, too.

    The website states that "Past performance is not indicative of future results....There is no guarantee that the strategies discussed will prove to be profitable. Formula Investing reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs."

    That said, it's an interesting idea, and maybe even worth reading further. I'd be interested to know if "buy-and-hold" fits with Greenblatt's methodology.

  • Report this Comment On April 19, 2011, at 7:44 PM, DDHv wrote:

    I'm using a variation. When setting up buy limit bids, they are ranked and priced between two year low and current price, with the ones thought best closest to the current price. When setting up sell limit bids, they are between two year high and current price, again with the ones thought to be the best sells closest to the current price. This is overridden when needed.

  • Report this Comment On April 25, 2011, at 1:15 AM, jswillsjr wrote:

    I've a Greenblatt client through Formula investing for about 15 months, and so far, so good. I just read the new book, and it's good - essentially restating the Little Book thesis and explaining how value weighting works (vs other forms of weighting). It's essentially putting the Little Book into a mutual fund, but with more stocks in it to take out some of the volatility that the 25 stock MF portfolio typically sees.

    The simpler answer is the better one.....

  • Report this Comment On November 25, 2012, at 8:47 AM, JohnCLeven wrote:

    Seems like a decent formula that could be made even better simply by investing in companies that both pass the magic formula screen AND have wide economic moats. Also free cash flow yield may be more useful than earnings yield.

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