The Little Book That Beats The Market, by Joel Greenblatt, is an interesting book but it is indeed little, to the extent that it can be read in one or two sittings. Greenblatt says that his aim is to teach his children (spin-offs) how to make money for themselves. To do this, he advocates a form of system investing that aims to buy a portfolio of above average companies at below average prices. Every year the portfolio is sold and replaced. Greenblatt presents plenty of statistics to prove how his system has worked in the past and explains why it will continue to work in the future.
How does it work?
Greenblatt’s system, which he terms the Magic Formula, uses two criteria to evaluate shares:
- Cheapness
Cheapness is determined by earnings yield (EBIT/Enterprise Value), with a high earnings yield obviously better than the low variety. - Quality
Quality is determined by Return on Capital (EBIT/Net Working Capital + Net Fixed Assets). Companies that turn more of their capital into profits are better.
He recommends buying a portfolio of 20-30 shares and selling them after a year, before repeating.
The system, to my eyes, looks like a bit of Graham and a bit of Buffett. Graham is represented by the cheapness and Buffett the quality. Although I have never heard WB advocating selling after a year and I doubt that he would consider twelve months sufficient for the benefits of quality to emerge.
How do you do it?
This part surprised me. Greenblatt spends a lot of time pushing his system, its results, the logic etc. I have a cynical streak and was waiting for the sucker punch, but there doesn’t seem to be one. His website www.magicformulainvesting.com is free to register with and as simple to use as a toothbrush. There seems to be no selling on the site and no spam has (so far) emanated from it.
Having run the screen this morning, a real motley crew of companies is proposed, including: Apple, Cisco, Herbalife (this is a controversial one and the current hedge fund darling/short), Microsoft, Sturm Ruger, Smith & Wesson, and Northrop Grumman. Normally looking at a selection of companies proposed by a value-based screen would put you off (their unpopularity makes them cheap), but this lot looks ok (if you don’t object to firearms).
What else does the book contain?
There is plenty of advice about how to think about stock prices. In my experience, this subject is as practical as any other for learning about investing because it teaches you how to view market volatility and fashions. Anyway, to explain this, Greenblatt’s wheels out Ben Graham’s trusty old Mr. Market metaphor, i.e., the manic depressive stock salesman that we all either welcome with tea and biscuits or shun like a rabid dog, depending on the prices he offers that day.
UK-based investors
Unfortunately the website covers American-listed companies only. To set up your own screen, Greenblatt recommends using ROA (Return on Assets) in place of return on capital, and suggests looking for at least 25%. From the resulting group of stocks, he suggests screening for those with the lowest P/E ratios, in place of the earnings yield component of the formula. Financials and utilities should be eliminated from the results, along with any companies with a P/E lower than 5.
A nice little read
I enjoyed this book. It assumes zero knowledge of markets, business, or investment and its concepts are expressed clearly and precisely. Greenblatt’s record is excellent and one book written by somebody with a track record like him is worth a thousand by experts you have never heard of.
I will take more from the principles of the system than the system itself, because I don’t like the idea of selling all my holdings every year. I know that a gardener will tell you the importance of pruning, but I have never heard one advocating that you kill every shrub in your garden once a year, so why would you sell a perfectly good company after year? If you are lucky enough to find a great company to buy into at a good earnings yield, why not just sit back and enjoy it while saving the money on broker fees?
That said, the two components that make up his system: looking for cheap companies with high returns on capital is the distillation of what equity investment is all about and that by itself makes a worthwhile takeaway from the book.