Joel Greenblatt, well-known Hedge fund manager, author and creator of  the ‘Magic Formula’ investing books, is out today with a new book where he reveals his secret to investing.  The book’s title is: “The Big Secret for the Small Investor: The Shortest Route to Long-Term Investment Success”

This “secret” is not a new method for picking stocks (his Magic Formula does that exceedingly well), the secret is better asset management.  Specifically, placing larger bets on stocks which are selling at deeper values.  Greenblatt’s firm has created stock market indexes using this “Value-Weighting” approach.  He describes it in a Morningstar article as:

[emphasis mine] “We just took the logic that, if we can buy a stock at a bargain price that we want to own more of that one. So, instead of weighting by market cap or equally weighting or by economic size, we weight by how cheap we can buy a company. So, the bigger bargain that we find, the more we own of it. So, we actually took the largest 1,400 companies listed in the United States, and we put together an index of 800 to 1,000 of those companies. And we didn’t equally weight them, we weighted them according to value.

So, we have heavier weights in those stocks that we believe are the cheapest, and we have very simple metrics that we use to decide which are the cheapest stocks and we buy more of those and every day we go out and rebalance the portfolio, so that it’s constantly and continually rebalanced towards the cheapest stocks that we can find based on those simple metrics. And over time, over the last 20 years when we tested them doing this kind of thing beat a market cap-weighted index by about 6% a year and it had the same volatility and the same beta as market cap-weighted index, but you’ve got six extra points which was very exciting to us and it makes total sense to us. Why wouldn’t you want to concentrate in the cheapest stocks that you can find?”

Any of this sound familiar?  Sounds exactly like the Kelly Formula to me.  The Kelly Formula gives you the optimal fraction of your wealth to place in any betting/investing situation.  The Kelly Formula directly addresses Greenblatt’s secret –  to weight your portfolio heavier with the most undervalued stocks.  Greenblatt doesn’t give details of his own weighting formula – but I’ve done that for you in this article:  The Kelly Formula for Stock Investing: Growth-Optimized Money Management.

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New Stock in my Portfolio

Last week I purchased Hewlett-Packard (HPQ) at $40.30.  I calculate HPQ to be 35% undervalued.  HPQ has been a consistent grower of Owner Earnings (Free Cash Flow).  I used my Kelly Formula spreadsheet to determine how much to invest.  HPQ is not deeply undervalued, and being a Tech stock leads me to a lower confidence than usual.  I ended at a 3% commitment to the stock.  This stock will be followed on the ‘Current Portfolio’ tab on the spreadsheet which is accessed on the Home page (viewable with a free Google Account).