The Little Book That
Still Beats the Market
About Author
Joel Greenblatt (born December 13, 1957) is an American
academic, hedge fund manager, investor, and writer. He is a value investor,
alumnus of the Wharton School of the University of Pennsylvania, and adjunct
professor at the Columbia University Graduate School of Business. He runs
Gotham Funds with his partner, Robert Goldstein. He is the former chairman of
the board of Alliant Techsystems (1994-1995) and founder of the New York
Securities Auction Corporation. He is also a director at Pzena Investment
Management, a high-end value firm.
Summary of Book
What should you be doing with all your hard-earned money?
You could put it under a mattress, lend it to a bank, lend it to a company or you
could invest it in a company and/or in the stock market. This is probably the
best alternative. The problem is just that most people have no business
investing in individual stocks on their own, or, as Joel Greenblatt puts it: "Choosing
individual stocks without any idea of what you're looking for is like running
through a dynamite factory with a burning match. You may live, but just still
an idiot." There is a solution though. Let’s learn in following
takeaways.
Takeaway #1: The
madness of the markets:
Think of a company, any company. Let’s take Amazon. During the last year, you could have bought Amazon for as low as $1377, and as high as $2012, a price difference of about 50%. Not just that, but the value of the whole company bounced from about a $1 trillion, down to approximately $650 billion, and then back up to $1 trillion again. Here point is that, Amazon - the business - didn't shift in value that quickly. The market is simply overreacting to the information that it is presented with. But this all may just be a fluke, maybe we, when asked to pick a company, happen to pick an extremely volatile one. Let’s take another company GAP. During the last year, you could have bought GAP, America's largest fashion retailer, for as little as $18 per share and as high as $31 per share. That's an even bigger difference, more than 70%! Do you think that GAP sold 70% more clothes ten months ago than they do today? NO! Clearly, at times, the market doesn't know what it is doing.
Takeaway #2: How much
is a business worth?:
When looking at these fluctuations, it's fairly simple to
tell that the market isn't always efficient. Sometimes, greed is ruling and
prices are too high, and at other times, fear is ruling, and the prices are too
low. Suppose that the value of the Amazon (as a business) fluctuated between
$1,500 and $1,700 during the last year,
while the prices fluctuated between $1,377 and $2,012. If you could state this
with any kind of certainty, becoming rich trading Amazon stocks would be a
really simple task. It will be like just buy it whenever the price goes way
below $1,500 and sell it whenever it goes way above $1,700. The problem is it
is not that simple. Let's take an example. One of your friends owns a shop
called "The Swedish Merchant". It sells only Swedish stuff. The shop
made a profit of $100,000 last year. How much would you be willing to pay for
it, knowing this? Well, your guess is as good as mine (as long as you guessed
somewhere between $500,000 and $2 million). In the stock market, you're
typically provided with more information than this before you ask to determine
the price of a business, but the difficulties are the same nonetheless.
Firstly, $100,000 is just what The Swedish Merchants earned last year. We must
determine if it, after our purchase, will be able to generate more or less than
that, in the coming year. Secondly, we must decide how confident we are in that
prediction. And thirdly it's not just about the next year potentially we could
own The Swedish Merchant for a very long time. So we have to estimate how much
the business will earn 5 to 10 years from now as well, in order to be able to
set a definite price tag on it.
Takeaway #3: PE(Price
To Earnings) and ROA(Return On Assets):
So far, we've concluded that stocks sometimes sell at a
discount from their underlying value, but that it's very difficult to decide
WHEN that is happening. So is it hopeless? Let us take The Swedish Merchant's
most fearsome competitor - "Just Broccoli". The Swedish Merchant
earns $100,000 per year, like I presented before, while Just Broccoli earns
$50,000. The price of the businesses is $1 million each. Which one would you
rather buy everything else equal? You would buy The Swedish Merchant, of
course. Here, you only pay $10 for every $1 in earnings. In Just Broccoli's
case, you pay $20 for every $1 in earnings. The Swedish Merchant would pay your
initial investment back in 10 years, compared to Just Broccoli's 20 years. In
the stock market, the most common way of measuring this, is through the so called
price to earnings, or price to earnings ratio. The price to earnings ratio is
calculated by taking a business current price and dividing it by its earnings.
The price to earnings of The Swedish Merchant is 10, and that of Just Broccoli
is 20. This is the first point of this takeaway - you would rather own a
business with a low price to earnings than a high one. Simultaneously, price is
not everything. Even buying at a low price to earnings can result in a
disastrous investment. You must also make sure that you buy a good business.
This is where return on assets, or ROA, comes into play. Let's say that
building that store of The Swedish Merchant cost $500,000, and the store of
Just Broccoli also cost $500,000. Everything else equal, would you rather invest
in the company that can build stores with $100,000 in profits, for $500,000, or
the company that can build stores with $50,000 in profits, for $500,000? Once
again, you would prefer The Swedish Merchant's business¨. This ratio is
referred to as return on assets, or ROA. The higher, the better. It says
something about the quality of the business, and with comparable companies, it
can often show you which of the companies that possess the best moat, something
that Warren Buffett loves to see in his investments.
Takeaway #4:
The magic formula:
If you stick to buying good companies, or in other words
those with a high ROA(Return On Assets), while buying these companies at low
prices, or in other words when their price to earnings ratios are low, you will
end up buying under-priced businesses. Joel Greenblatt's even constructed a
system that will do just that for you, which he calls "the magic
formula". It's simply ranking companies according to their combined score
in these two regards - the quality and the price of the business. Intuitively,
it does make a lot of sense. And when back testing it, it does make a lot of financial
sense as well. During the 17 years period that Joel Greenblatt evaluated the
magic formula, it outperformed the overall market by about 18%, returning 30.8%
per year rather than 12.3% per year.
With such a return, $10,000 turned into almost a million in 17 years, as
compared to the markets more modest increase to just $70,000. Some of the
companies that you'll invest in using this formula, will turn out to be crappy
investments. But the important thing is that ON AVERAGE, it will help you to
find true bargains. If you're not impressed by the results yet, consider what
happened when Joel Greenblatt divided companies into ten different groups,
ranking them with the formula.
As you can see, it's
quite a good predictor. The best group performed better than the second-best,
and the second-best perform better than the third-best, and so on. Crazy!
Takeaway #5:
Step-by-step instructions:
Here comes a step-by-step instruction on how to invest using
the magic formula.
1. Go to magicformulainvesting.com
2. Choose a company size. 50 million or bigger should do.
3. Follow the instructions on the site to get a list of
top-ranked magic formula companies.
4. Buy between five and seven of these companies. Spend
20%-33% of the capital that you intend to invest.
5. Repeat step 4 every two to three months, until all your
capital is invested. This should result in a portfolio of about 20 to 30
stocks.
6. Sell the stocks after holding them for a year. For tax
purposes, hold the winners a few days longer than a year, and the losers a few
days shorter. Repeat step 4 with the money from your selling.
7. Continue the process for many years
If you are like me, and you find investing to be a very
challenging and stimulating interest, that you don't want to throw away for
some automatic formula (with a name that makes it sound like a scam, by the
way), you could use it for screening purposes only. For example, find the top
100 companies according to the magic formula and then pick your favorite 10 out
of those.
A quick summary:
Market prices fluctuate more than underlying business values. It's difficult to estimate the future earnings of a company, and therefore also what a fair price of that company should be. Most investors have no business doing this. Price to Earnings and Return Of Assets are two of the most (if not the most) important quantitative factors to consider when buying stocks. According to the magic formula, if you buy stocks with a low Price toEarning and a high Return Of Assets, you will outperform the market by a wide margin over time. Go to magicformulainvesting.com and get started! And last but not least .. It is difficult to come up with something that rhymes with magic formula. Cheers!
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