Reese on New Guru Model, Economy

In his latest Hot List newsletter, Validea CEO John Reese unveils a new guru-based stock selection model, and tells readers that continuing economic woes don’t have to mean continued trouble for the stock market.

Reese’s new Guru Strategy is based on the writings of hedge fund master Joel Greenblatt. Greenblatt created quite a stir in the investment world in 2005, when he published “The Little Book that Beats The Market”, in which he explained how investors could produce outstanding long-term returns using his simple “Magic Formula”. The purely quantitative approach had just two variables: return on capital and earnings yield. Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500’s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Reese has been internally tracking his Greenblatt-based model since late 2005, and it has beaten the market in each of the past three years.

In reality, Reese writes, the “Magic Formula” is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. (The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.)

While the Greenblatt stock-picking approach is purely quantitative, Reese notes that Greenblatt stresses the mental aspect of using the “Magic Formula”. To Greenblatt, the hardest part about using the formula is having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn’t always work — a notion that is true for any good strategy.

Reese also touches on the economy’s continued struggles, and warns stock investors not to mistake the economy for the stock market. Even if the economic news continues to be rough, he writes, that’s no guarantee that stocks will fall. Consider that in two very high unemployment periods ((1975 and late 1982), bull markets actually began about seven months and four months, respectively, before unemployment peaked.

The issue for stock investors is, as always, value, Reese says, adding that, based on a variety of measures — price/book ratios, forward price/earnings ratios, and even the ultra-conservative 10-year P/E ratio — stocks are undervalued. “That means it’s a good time to be buying (or staying) in stocks, regardless of the short-term economic fallout,” he says.

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