By Christopher M. Wright

NAME: Joel Greenblatt TITLE: Managing partner–Gotham Capital and adjunct professor of finance and economics at Columbia Business School BORN: 1957 EXPERIENCE: Greenblatt received his BS and MBA from the Wharton School. He is former chairman of the board of Alliant Techsystems, a public aerospace and defense company listed on the NYSE. In addition to launching Gotham Capital, Greenblatt also co-founded the Value Investors Club where successful applicants share investment ideas. He is author of "You Can Be a Stock Market Genius" (Simon & Schuster, 1997) and "The Little Book That Beats the Market" (John Wiley & Sons, 2006). For more information, go to magicformulainvesting.com

Hedge fund manager Joel Greenblatt's bestselling book, "Little Book That Beats the Market," outlines a simple yet winning stock formula. "The 'Little Book' is one of the best, clearest guides to value investing out there," the Wall Street Journal wrote.

In 1985, Greenblatt launched Gotham Capital, a hedge fund investing in value stocks and special situations such as spinoffs, restructurings, and takeovers. Gotham returned all of its outside capital in 1995 and currently only manages its partners' capital. Greenblatt and his partners have another fund, Gotham Asset Management, which manages some assets itself but also selects other money managers using a 'fund of funds' approach.

Portfolio recently sat down with Greenblatt to learn more about his investment strategy and thinking behind the book, as well as his view on REITs.

Portfolio: You have said that the stock market is inefficient, that it does not price all stocks correctly. Do you remember the moment of your epiphany, when you realized that the market is irrational, at least in the short run?
Greenblatt: I can't tell you the exact moment, but just observing the newspaper every day and looking at the 52-week high and low lists, it didn't make much sense that all the values could be correct, or that so much had changed that prices could bounce around that much.

Portfolio: In your book, you say Benjamin Graham and Warren Buffett influenced your thinking. Describe the contribution each made to your investing philosophy.
Greenblatt: Ben Graham said "buy things cheap," for less than they're worth, and you'll make money. Buffett added to that with "buy good businesses cheap." The combination of those two is what turned into the "magic formula" I wrote about in my book.

Portfolio: What is your magic formula?
Greenblatt: In a nutshell, the formula is buying good companies cheaply. A good company is one that earns a well above average return on capital. If you can buy a portfolio of "good" companies at below average prices, you will have a successful investment strategy.

We rank all stocks based on return on capital, the higher the better, then we see if we can buy them cheaply. We rank them again on their earnings yield, which is how much they earn relative to the price we are paying. The ones with the best combination of rankings are the ones we buy.

Portfolio: The book makes clear that this is on a three-to-five year time horizon and describes a method for turning it over during that time. Are the two ranking factors equally weighted?
Greenblatt: Yes. Also, at Gotham Capital we use our own estimate of normalized earnings. In other words, what we think a company will be earning two to three years from now in a normal environment. If you're capable of predicting earnings several years down the road, then you can apply the magic formula yourself. If you're not capable of doing that, then you can just use last year's earnings, or you can go to our Web site and use the rankings our computers compute.

Portfolio: Why do you exclude financial and utility companies?
Greenblatt: There's nothing wrong with those companies, it's just that they're financed in a different way. Their capital structure is much more leveraged than the typical company.

Portfolio: True, looking at a handful of electric utilities, I see long term debt as a percentage of total capitalization of 60 percent or more, much higher than the average company. Do you agree with observers who say that your formula is a type of value investing?
Greenblatt: Sure, value investing is defined as figuring out what a company's worth and paying a lot less.

Portfolio: Does the magic formula accurately describe how you and Gotham Capital actually invest? If so, what results have you obtained?
Greenblatt: We use the principles behind the magic formula and, as I mentioned, our own estimates of normalized earnings. We've earned more than 40 percent annualized returns since inception in 1985.

Portfolio: In the book, you report 30.8 percent annual returns for the magic formula for a 17-year backtesting period, versus the overall market average of 12.3 percent in the same time period. Other researchers were not able to replicate your backtesting results, although some have come close. How do you explain that?
Greenblatt: Barron's tested the formula using a different database. One researcher came up with a 28 percent per year return in the article. The other used a database that does not take out one-time gains. The stocks selected by that database may look like they're earning the most, but the testing was not accurate because of one-time gains. If you use those higher earnings numbers, of course you get returns that are not as good. The database I used stripped out one-time gains so we got an accurate group of companies based on normal earnings.

Portfolio: Your critics also say no one knows whether the formula will work in the future.
Greenblatt: As I say in the book, the magic formula does not always work. There are one, two, and three-year periods where it does not beat the market. You're buying above-average companies at below-average prices. Unless you think what you're doing makes sense over the long term, you will not stick with it when it underperforms in the short term.

Portfolio: I went to your Web site but didn't see any familiar REIT names in the top 100 picks. Your formula tends to turn up software firms, service companies, and brand managers with few tangible assets. What is your view of REITs as an investment proposition?
Greenblatt: I'm not an expert on REITs... we have not yet developed a formula specifically for REITs, but will eventually.

Portfolio: Do you or Gotham have any REIT investments?
Greenblatt: It's not usually our practice to trade in REITs, but we have one REIT involved in a special situation. My previous book "You Can Be a Stock Market Genius" describes what we do in the special situation world. [As described in that book, special situations include mergers, bankruptcies, asset sales, rights offerings, and risk arbitrage, among other things.]