Beyond "The Little Book That Beats the Market"

While many hedge fund managers are ultra-secretive, one former hedge fund manager has identified, and published, a very simple strategy that will enable any individual investor to beat the market over long time periods. We'll take a look at it, and then I'll tell you about another one of his strategies -- one that's even more powerful.

The two pillars of the Magic Formula
In The Little Book That Beats the Market, successful value investor Joel Greenblatt's describes a strategy ("Magic Formula Investing") for picking stocks based on a quantitative ranking of stocks according to just two criteria:

• Buy 'em cheap! As a value investor, Greenblatt doesn't like to pay up for stocks. He looks for a low enterprise value to earnings before interest and taxes ratio. EV/EBIT is similar to the P/E ratio, but it takes into account the different amounts of leverage between companies -- EV is equal to a firm's market capitalization plus its net debt.
• Buy 'em profitable! Cheap is important, but if a business isn't profitable, there is almost no price that is too cheap. Better yet, if a company is highly profitable, it could indicate that it has established some advantage over its peers. Businesses that are protected with a moat are the most likely to outperform over long periods of time.

The following table contains seven stocks that are the product of Greenblatt's Magic Formula:

Sources: MagicFormulaInvesting.com and Capital IQ, a division of Standard & Poor's.

Once you have your screen results, Greenblatt recommends buying the stocks in sufficient number (20-30, say), holding them for approximately a year, and then repeating the process. It's that simple, and it appears to work very well (take that, hedge fund quants!). In Can Individual Investors Capture the Value Premium, published in the Journal of Business & Economics Research, the author found that the Magic Formula strategy produced an annualized return of 19.1% from 1998 to 2006, beating the market by a huge margin (16.5%).

Better than the Magic Formula?
Did Greenblatt himself follow this strategy as portfolio manager of the hedge fund he founded, Gotham Capital? Actually ... no (he probably hadn't developed it yet). Instead, he focused on another area of inefficiency in the market: special situations. Remarkably, he produced returns that make the Magic Formula's numbers look downright mediocre: From April 1985 to January 1995, he compounded his investors' capital at an annualized rate of 50%! In the space of less than 10 years, those returns turned a $10,000 stake into $519,700.

Special situations investing focuses on stocks that are undergoing a corporate event (spinoff, bankruptcy, merger, etc). The approach does share one characteristic with the Magic Formula, in that they are both value-driven; however, they are at the polar opposite in terms of process. Instead of just running a screen to produce a buy list, every special situation is unique and requires extensive research. The payoffs to this time-intensive process can be very rich.

The case of the two Marriotts
Here's a great example that Greenblatt participated in: After an ill-advised shopping spree in the 1980s, hotel company Marriott had accumulated heavy debt and some unattractive real estate. The solution was to separate Marriott into two companies: Host Marriott, for the traditional management contracts business -- a capital-light money machine -- and Marriott International for the rotten real estate assets/ debt.

Guess which shares institutional investors decided to hang on to once the spinoff complete? Investors sold Host Marriott shares indiscriminately, driving the price down. Meanwhile, Greenblatt was ready to strike gold after digging around in the filings relating to the spinoff transaction.

Three redeeming qualities
First, the Marriott family would own 25% of Host Marriot. Even if public shareholders left it for dead, insiders hadn't. Second, Marriott CFO Stephen Bollenbach, a restructuring whiz and the man behind the idea for the spinoff, would head up Host Marriott. Third, assuming it didn't kill the company, the heavy debt transferred to Host Marriott could turbo-charge returns for common equity holders.

On that basis, Greenblatt was willing to bet that -- at the right price -- Host Marriott's stock could turn into a swan. Sure enough, it ended up almost tripling within four months of the October 1993 spinoff. (Over the next five years, Host Marriott then spun off Host Marriott Services and Crestline Capital -- a gift that kept on giving!)

It's your turn
The case of Marriott shows just how lucrative special situations can be, but they aren't free money. Each one requires in-depth research and a very sure grounding in stock valuation. Those are things Motley Fool Special Ops' Tom Jacobs provides in the search for genuine opportunity. If special situations are something you might be interested in, simply enter your email address in the box below in order to receive a video explaining three of Tom's favorite opportunities today, along with an invitation to join Special Ops when it reopens today.