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The Little Book That Beats the Market, published in 2005, accomplished what most investing books don't: It became a bestseller. Its author, longtime value investor Joel Greenblatt, argued that individual investors can succeed with a basic approach: Buy 20 to 30 stocks based on their return on tangible capital and earnings yield, and hold 'em.

But 53-year old Greenblatt, the co-chief investment officer of the more than $700 million-in-assets Gotham Asset Management, discovered that many individuals investors are not uncomfortable enough with their own stock-picking ability to follow the "magic formula" he'd laid out in The Little Book. So, he wrote another.

The Big Secret for the Small Investor, published this year, suggests value-weighted indexes Greenblatt constructed and back-tested. The U.S. index has an annual return of 16.1% from 1990 through 2010 -- versus 9.5% for the Russell 1000 and 9.1% for the Standard & Poor's 500. Barron's interviewed Greenblatt at his Manhattan office.

Barron's:What is your definition of value investing?

Greenblatt: It's about figuring out what something is worth, and then paying a lot less for it. However you go about figuring out what a company is worth, if you can buy it at a reasonable discount to what Ben Graham called the margin of safety, that's the basis of value investing. It's not a particular ratio; it's really about a discount to value. Obviously, everyone tries to do that. One of the things that individual investors should think about is whether they are capable of valuing a company, because if they are not, investing intelligently in individual stocks isn't really doable.

Joel Greenblatt Roger Hagadone for Barron's

How does value investing stack up against other strategies over time?

There are all kinds of studies, and they are fairly consistent, showing that picking almost any ratio that's cheap relative to price -- whether it's earnings, cash flow, dividends, book value, sales, etc.–those stocks do beat the market over time.

Some metrics are better than others, and there are some ways of measuring, let's say, cash flow, that are better than others. When we think about price, it includes all the liabilities that you take on when you buy a company. But all value metrics work for the same reason: There is an aversion to owning a company that is out of favor, and there are different ways to take advantage of that natural aversion.

With tons of people going into hedge funds, mutual funds and all kinds of active management, you'd think it should be tougher for an investor to try to beat the market. But there is one area that has actually gotten even better over time: the long-term investing horizon. What I tell my business-school students is that if you get your valuation work right, and if you wait two or three years, usually the market will agree with you. But what happens in the short term could be anything. The world has become more institutionalized, as performance numbers become available on a daily, weekly and monthly basis. And as more fiduciaries are involved in the investment business, the time horizon of investors, clients and the actual managers has gotten shorter.

Greenblatt's Stock Picks RecentCompanyTickerPriceMHP$42.19MA282.10ARO21.74RTN49.20NOC65.36Source: Bloomberg MHP$42.19MA282.10ARO21.74RTN49.20NOC65.36Source: Bloomberg

Can everybody do the valuation work that's necessary?

There are a few ways to be a value investor. One is to do the work yourself. That means actually valuing a company. What I argue in the new book is that because the future is uncertain, it is very hard to know enough about many companies to do good valuation work on those companies. So what I suggest to professionals and to my M.B.A. students at Columbia University is, pick your spots.

Could you elaborate?

It means only evaluating companies where you have a strong amount of knowledge and good foresight into the development of that particular company/industry.

It is almost the opposite of how professional investors act. They usually buy 50 to 100 stocks, but it is probably hard to do good valuation work on more than a handful of companies at any one time.

I finished the most recent book with a quote from Ben Graham, in which he said, in part: "The main point is to have the right general principles, and the character to stick to them."

What are some key tenets of your philosophy?

I emphasize two principles. One is to buy cheap; the ratio we use is price-to-cash flow. We want to get a lot of earnings, and we want to get a lot of cash flow for the price that we are paying. The second metric we use is return on tangible capital. We simply say that if you open a store and you invest $400,000 on the inventory and displays and it spins out $200,000 a year, that's a 50% return on capital. In The Little Book That Beats the Market, I brought up an example of a store called Just Broccoli, where it cost $400,000 to open, for the inventory and building the store. But it only earned $10,000 a year -- a 2.5% return on capital. We tend to go for businesses that can reinvest their money at good rates of return on the tangible capital invested.

Tell us about the progression of your books.

The first book I wrote, You Can Be a Stock Market Genius, came out in '97. It was really a compilation of war stories about value investing. I wanted to look at all these places off the beaten path in value -- as well as in special situations, where you don't have as much competition, and you can, perhaps, more easily find bargains. Your valuations skills only have to be decent, not great, because you are finding large spreads that you can drive a truck through.

So even if you make some errors, you can still make a lot of money. When I wrote the book, I assumed people knew a lot. But that assumption was wrong. The book helped a lot of hedge-fund managers.

What about your second book?

In that book, I was talking about buying above-average companies at below-average prices. I thought I had laid out everything on a free Website [highlighting my model, which I called "The Magic Formula"], www.magicformulainvesting.com, that I had set up. But even following this investing strategy with my own kids, I realized that keeping records for all those companies wasn't as easy as I thought it was.

In the most recent book, I talk about trying to take advantage of other people's systematic aversion to companies that either face near-term uncertainty or whose near-term outlook doesn't look so great or is not as good as it had been. People avoid companies like that.

So, rather than having just 20 or 30 names in a portfolio, as we suggested in my previous book, it turns out that another problem that individual investors have is dealing with volatility -- this is another subject that I address. By owning more names, you lose a few points in return–but you dramatically decrease the volatility of your returns. The real questions are: Which strategy is appropriate for you; which one will you stick to over the long term; and how much volatility can you handle?

How can individual investors execute this theme of holding a larger group of stocks?

Index funds are a popular vehicle, but you have to consider some key factors. Let's say that index funds outperform about 70% of active managers.

So you could say, "Let let me go find the other 30% that are outperforming." But if you look at their three-, five- and 10-year returns, the funds that outperformed over that period of time usually don't continue to outperform over the next three, five and 10 years, which is really what your goal is. So it is just as hard to pick an active manager that is going to do well in the future as it is to pick a good stock.

What are some of the pros and cons of the different types of indexes out there?

There are trillions of dollars put into market cap-weighted indexes like the Standard & Poor's 500 Index and the Russell 1000. But being market-cap weighted means that if the market is inefficient or emotional over the short term, as I believe it is, some stocks are overpriced and some are underpriced, rather than all stocks being efficiently priced.

So what will a cap-weighted index do? It will buy too much of any stock that is overvalued, and it will buy too little of a stock that's at a bargain price. And what the facts say is that over time that inefficiency costs you 2% a year.

So there are a couple of simple ways to fix that. You can equally weight. Under that set-up, you can still make plenty of errors -- but they are all going to be random, not systematic.

Rob Arnott of Research Affiliates came up with fundamental index weights, but the errors in that kind of index also are random. So we thought that, being value investors, why don't we just put more weight in the cheaper stocks?

Which is your value index?

Right. We put together a value-weighted index that looks at the largest companies and ranks them according to how cheap they are. That seems to add 6% or 7% a year in returns, versus the market-cap-weighted indexes -- rather than just 2% added by the equally weighted indexes and the fundamental indexes.

With all their flaws, cap-weighted indexes still beat most active managers. But you can improve results by buying equally weighted or fundamentally weighted indexes, and you can do even better with a value-weighted index. (See www.valueweightedindex.com.)

What is the composition of your value index?

In the U.S. index, we have 800 to 1,000 names selected from the largest 1,400, based on market cap -- depending on what's available at cheap prices.

That index over the last 20 years, as of Dec. 31, would have beaten the S&P by seven percentage points a year, with the same volatility and the same beta.

I don't profess to know what its performance will be, going forward. But that was the last 20 years.

Cap-weighted indexes change every day as prices move, so we do adjust. For example, if you have a $1 million in this index, we do about $3,000 to $4,000 worth of trades a day on average to just reweight toward the cheapest stocks.

How does the market's valuation look and where are you finding opportunities?

We did a study looking back at the last 23 years of our proprietary measurement for trailing free-cash-flow yields. The Russell 1000 was in the 77th percentile toward cheap, and the Russell 2000, which is a barometer for small-cap stocks, is in the 63rd percentile toward cheap.

That's not the whole story, because we could have an aberrational period where the last 23 years aren't representative of what will happen in the future. But during that period, the market has been up about 8% a year. That's pretty good.

We're in the zone of fair value. So, even though we say that the market looks cheap, based on our work, I think the market is, at worst, fairly valued. That means 6% to 8% annual returns going forward from here. It could mean the market drops 25% next week, or it goes up 25%. But over time we're in the range of fair value.

What about a few stocks that come up on your list as being attractively valued?

We have an overweighting in consumer-discretionary stocks. Why is that? They are cheap because people are worried about the consumer dropping dead, because of the artificial stimulus from the government. We also have an overweighting in financials and health care, and we are underweighted in energy.

Why are you underweight energy?

Those stocks just come out expensive, and we are slightly underweight in information technology. I can name some stocks that are coming up on our list. But this is not based on our extensive research; they are just the types of names that come up cheap now on our screens.

One stock that is very cheap is McGraw-Hill [ticker: MHP], which has a very good business. We look for high returns on tangible capital, and it certainly has that. But, for obvious reasons, it is not a good idea for Standard & Poor's, which McGraw-Hill owns, to rank a lot of stuff AAA that ends up defaulting. So there is a lot of legal overhang there that people are concerned about, as well as their future business and their franchise. [But the metrics are good for a turnaround, sooner or later.]

What about a few other examples?

MasterCard [MA] comes up cheap, as people are worried about the effects of changes in interchange fees.

Turning to retail, there's the teen-clothing outfit, Aérospostale [ARO]. People are worried about its margins [versus its competitors', which is why it is cheap].

Other names that come up on our lists include Raytheon [RTN] and Northrop Grumman [NOC]. Everyone knows we are pulling out of Iraq and Afghanistan over the next few years, and we have a president who is not, probably, going to be a big proponent of expanding the defense budget over the next few years.

So what's the common thread for all of these investments?

Legg Mason's Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

The way we make money as a group is that we don't pay a lot for anything, and most of the stocks we buy have low expectations. So if the future is a little better or a lot better than the low expectations -- it doesn't have to be great -- you have the chance for asymmetric returns on the upside. And, hopefully, you don't lose much on the ones that don't do better than the low expectations, because you didn't pay much for them in the first place.

Thanks, Joel.

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