Aha! So growth's not really back, it's just that growth can be purchased at a reasonable price. Kind of like the clearance sale at Macy's where the Jones New York outfit is marked down 50 percent, plus you can take off another 30 percent at the cash register.

The bogey that's hard to beat Professional money managers have long sought a formula to beat the market, and many consider the Standard & Poor's 500 their benchmark. Some are in the value camp, others the growth camp, and some, a blend of the two.

Advocates of indexing strategies claim that trying to beat the market is a fool's game, and to buttress their argument, they point to the record: Index funds beat actively managed funds, run by professional money managers, hand over fist the majority of the time. Over the 10 years ending in December 2005, only 7.6 percent of all actively managed domestic stock funds were able to outperform the S&P 500, according to Morningstar.

The little book that could Joel Greenblatt notices that pricing anomalies are not rare occurrences in the market. Look at the 52-week highs and lows of any stock price, he says, and more often than not you'll see a big spread. Look at the range that General Motors traded over the last year: low of $18; high of $37. IBM: low of $72; high of $95. Abercrombie and Fitch: low of $44; high of $74. Do these prices always reflect business values? No, he says, they reflect the mood swings of Mr. Market, his personification of the broad stock market.

Greenblatt, a former hedge fund manager, penned "The Little Book that Beats the Market," which comes wrapped in a rich iridescent indigo jacket that gleams with promise. It's the Rosetta stone of value investing, and even holds the key to a magic formula. That formula can help ordinary investors get rich much more quickly than if they buy an index fund, he says. How can investors do that? By buying good companies at below-average prices.

The lesson that Malkiel speaks of isn't lost on Greenblatt, who says:

• "Over the long run, it's a completely different story: Mr. Market gets it right."

That's why, Greenblatt maintains, it's not so risky to buy a good company at a depressed price since eventually the market will recognize its true value. And about his magic formula, he goes on say almost recklessly: "The formula is simple, it makes perfect sense, and with it, you can beat the market, the professionals, and the academics by a wide margin. And you can do it with low risk."

Right about now, many would laugh uproariously at these too-good-to-be-true claims -- particularly academics and professional money managers. Except that it's not easy to dismiss Greenblatt. His background is impressive: He's the founder of Gotham Capital, a private investment firm that has achieved 40 percent annualized returns since its inception in 1985. He's professor on the adjunct faculty of Columbia Business School and former chairman of the board of a Fortune 500 company. He holds a B.S. and an M.B.A. from the Wharton School. These are some serious credentials.

Greenblatt's magic formula looks at only two financial ratios: high earnings yield and high return on capital. "For earnings yield, the formula looks for companies that earn a lot compared to the price we have to pay. For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings."

So how does the average investor identify these good companies? Greenblatt's book, which gives step-by-step instructions, goes hand in hand with his magic formula investing Web site, which ranks these companies in descending order. In other words, he's giving away the goods, all for a $20 investment in the book.

Greenblatt has good reason to be psyched about his system. In his words, "Over the last 17 years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year. Investing at that rate for 17 years, $11,000 would have turned into well over $1 million. Of course, for some people, that might not seem like such a great return. On the other hand, those people are basically nuts!"

So does this give the boomers who aren't adequately prepared for retirement a chance to make up for lost time -- by creating a portfolio on steroids based on his formula?

Before you get too excited, the above results occurred when Greenblatt ranked 3,500 of the largest companies in the U.S., which included companies with a market capitalization of as low as $50 million. When he narrowed his test to see how his system worked ranking the largest 1,000 stocks, he came up with a 22.9 percent annualized return. An $11,000 investment over 17 years would have grown to only $366,248. Still, that's a lot better than $80,245 -- what you would have gotten from an S&P 500 index fund over the same time frame.

Some caveats Indexing enthusiast Larry Swedroe, author of "The Only Guide To a Winning Investment Strategy You'll Ever Need," believes it's more risky, not less so, to invest in value stocks. "They are more leveraged, have higher volatility of earnings, greater bankruptcy risk, et cetera." Also, he points out, "Often data presented on strategies ignores costs. While strategies don't have costs, implementing them does." Such costs would include trading costs, commissions and taxes, among other things.

"Value stocks are definitely riskier, so there's no free lunch," he says. "But perhaps there's been a free stop at the dessert tray. The interesting thing is that going forward, that free stop may have been eliminated." He refers to the efficient-markets hypothesis, which posits that stock prices reflect all known information about companies. "The very act of discovering an anomaly and exploiting it makes it go away," he says, since investors quickly act on the latest information, bidding up any bargains in the market.

But that's not likely to happen with this magic formula, says Greenblatt, because -- are you ready? -- the magic formula doesn't always work well. In fact, there were some stretches when the formula did worse than the market for three years in a row. Long periods of mediocre performance will test the mettle of less patient investors, and many will abandon the strategy altogether.

"That's why we're so lucky the magic formula isn't that great," Greenblatt says. "That means that those who do stick with it have a better chance of success. The only thing is," says Greenblatt, "you're going to have to really believe in it deep down in your bones.

If you have a comment or suggestion about this column, write to boomerbucks@bankrate.com.

Posted by toughiee on Thursday, February 02, 2006 at 5:33 PM | Permalink