Greenblatt's Strategy Picks Four Winners

• ByJohn Reese, RealMoney Contributor
• On 1:30 pm EDT, Tuesday October 27, 2009

Is it possible to outperform the market using a strategy that uses only two variables? On Dec. 2, 2005, I started tracking a portfolio I based on the writings of Joel Greenblatt, a strategy he called his "Magic Formula." He described this formula -- which is "magical" in that it includes only two variables -- in his bestseller The Little Book That Beats the Market.

No sophisticated investor would take a chance on a formula based on magic, and there is not much reassuring about a book that calls itself "The Little Book That Beats the Market," but I have looked at Greenblatt's strategy in detail and decided to include it among the other legendary strategies I offer on my site for one reason -- it works.

It's not magic, despite its name, and there is nothing little or insignificant about it. As a way to invest in the stock market, Greenblatt's strategy sits comfortably among those of the giants of the investing world. Since I began following it, it is up 46.6%, compared to a loss of 14.5% for the S&P 500 over the same period. Year to date, the Greenblatt strategy is up a sterling 64.0%, as compared with the S&P 500's gain of 19.7%. You can see more detailed performance for it on my model portfolio page.

Why does the strategy work? Because it looks it focuses on two variables that get to the core of successful investing -- profitability and valuation.

One of the two variables used is return on capital, which measures how profitably a company is using its assets. This is similar to return on assets, but ROC uses earnings before interest and taxes instead of reported earnings (which is typically used with return on assets) because debt payments and taxes can hide how well a firm's actual operating business is doing.

Why look at ROC? Because it is a measure of a company's competitive advantages. Companies with high ROC tend to be able to charge more than no-name competitors -- take for example Toyota vs. some of the Chinese carmakers reportedly interested in entering the U.S. market. Or perhaps the company has a strong competitive position -- as is the case with Google , which can offer capabilities to customers its smaller competitors cannot.

The second variable addresses earnings yield, but again, Greenblatt has some variations on a common theme. Once more he uses EBIT rather than earnings, and divides this by the value of the company, which includes the price of the company's shares along with the amount of debt used to generate earnings. Another way to look at this is that this variable measures the return one could expect if one bought the whole company, including its debt.

With these two variables (which he weights equally), he ranks the 3,500 largest stocks -- the higher the ranking, the better.

So which stocks are now highly ranked by this strategy? One is Pre-Paid Legal Services , which provides a form of insurance that reimburses members for legal expenses, much as medical insurance reimburses members for medical expenses. Its earnings yield is 21.19%, giving it a rank of 16 out of all stocks, and its return on total capital comes to 104.42%, earning a ranking of 32. However, when combined, Pre-Paid Legal Services is No. 4 among the stocks in our database. That's impressive.

Amedisys is another Greenblatt favorite. It provides home health care services in the Southern and Southeastern regions of the country. This company's earnings yield is 13.82%, which garners a ranking of 98, while return on total capital is 330.65%, a return that ranks fifth among the stocks in our database. Combined, Amedisys comes in at No. 8, a very strong result.

Another company that meets these tests is LHC Group , which provides both home- and facility-based health care services primarily to Medicare beneficiaries in the Southern U.S. Earnings yield for this company is 13.89%, good for a 95 ranking, while return on total capital is 122.23%, 19th among all stocks. Combined, its ranking is No. 9 out of our total database of stocks.

The strategy also likes venerable book publisher McGraw-Hill Companies , which is in the process of selling its Business Week magazine to Bloomberg. Its earnings yield is 12.42%, ranking it 149, while its return on total capital is 149.90%, earning a 13 ranking. In total, McGraw-Hill is ranked 13th among all the stocks in our database.

Greenblatt goes out of his way in his book to point out that, like all strategies, his will not work every month or every year. And that fact is what allows it to continue to work in the long term -- its strong track record and common-sense approach make this strategy one worth paying close attention to.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider Pre-Paid Legal Services to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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