Review of ‘The Little Book That Beats The Market’
It is a wonderful, short and precise book written by Joel Greenblatt. Wall Street Journal describes it as “the best, clearest guides to value investing out there “. The author explains a ‘magic formula’ for picking up stocks in your portfolio, which he has followed for the past 20 years.
About the author
Joel Greenblatt is the founder of Gotham Capital that has achieved a phenomenal 40% annualized returns for the last 20 years. He holds a BS and MBA from Wharton School. He is a professor of adjunct faculty of Columbia Business School, former chairman of the board of a Fortune 500 company.
About the Book
The book initially touches upon the concept of why investing in stocks is a wise thing to do with your money. It’s a way of indirectly making someone else create wealth for you, it’s a way of becoming entitled to a portion of someone else’s business future earnings. The other alternate methods of putting your money to ‘good’ use like keep it under a mattress or giving it out as loans unfortunately does not work well for compounding it.
But simply making a decision to invest in the stock market will not make you rich, the world isn’t so sweet! The real challenge is picking up your portfolio of 15-30 stocks from a list of thousands of publicly listed stocks available. Before we come to the part of stock selection let us understand the significance of intrinsic value of a business. Intrinsic value is the fair value of a business, which represents the true value of the business. It is hard to determine accurately because a lot depends on how the person estimating it perceives the quality of assets, or the future earning potential of the business. Although it is hard to determine the intrinsic value, a rough estimate of the intrinsic value is crucial for investing. Benjamin Graham, one of the greatest stock market thinker and writer of all time, talks about a concept of Mr. Market (an analogy for the stock market). Imagine you are partners in a business with a man known as Mr. Market. Mr. Market is subject to mood swings and offers to buy or sell his share of the business at different prices every day. The ideal step for you will be to sell when he is quoting above the intrinsic value and buy when he is quoting below the intrinsic value. But the question arises how do you know the intrinsic value and recognize whether the business is trading above that value or below it. The next part of the book deals with that problem and also the ‘magic formula’ that has worked so well for the author.
The magic formula covers two important concepts of investing.
1- The price/earning (PE ratio).
This signifies the price a business is available at, with respect to the earnings of the business. It is a measure of how cheap or expensive the market values a particular business. It is simply =
The price of a share / Earning per share
2. Return on invested capital.
It is the NOPAT / (Net working capital + net fixed assets)
NOPAT is net operating profit after tax. It is used to remove the effect of some windfall gain or exceptional loss life forex gain/loss, or some other income not related to the business operation of the company.
Net working capital + net fixed assets determine the amount of capital put into running the business.
This formula is the test of how bad or good quality the business actually is, how effectively the company is making use of the money put into the business.
Now the ideal combination will be to find companies which generate great return on invested capital but available at discounts to their intrinsic value. This is what the magic formula is all about.
- Rank all the public listed companies sin your universe in according to their PE ratios (from lowest to highest) & Rank all the companies according to their return on invested capital (from highest to lowest).
2.Add the rank number assigned to each company in both the lists and form a 3rd list.
- The top 30 companies in this list can be selected to form your portfolio
This simple formula has been used by the author from 1988 to 2004, a period of 17 years, to get a marvelous rate of return of 30.8%. Let that sink in!
Now let us address the concerns we may have while using the formula.
- if the magic formula has been giving superior returns compared to the market, why doesn’t everybody follow it, increase the prices of stocks identified using the formula and make the excess return over the market disappear?
The magic formula fared poorly relative to the market averages 5 out of every 12 months tested. For full year periods, the magic formula failed to beat the market averages once every four years. For one out of every six periods tested, the magic formula did poorly for more than 2 years in a row. During those wonderful 17 years for the magic formula, there were some periods the formula did worse than the overall market for 3 years in a row!
These periods of underperformance is good news for patient value investors wanting to apply the formula! It keeps most investors away from the formula thereby safeguarding the superior performance of the formula over the long term.
- The magic formula has worked for the author by selecting from a universe of 3500 stocks. What if we want to limit it to a smaller universe of only larger companies?
Let us raise the bar a little bit, if instead of top 3500 we make it top 2500 companies the formula still delivers a return of 23.7 percent CAGR versus the annual market return of 12.4 %, during the same period tested. If we want to restrict it further to the top 1000 stocks, it still gives an annual return of 18.9 percent over the same period beating the market comfortably.
- What if I am a person who understands how to analyze companies, read and interpret the financial statements, what can the magic formula possibly offer me?
The magic formula can be used as an effective checklist for filtering out the stocks needed to be studied. In this case a person can dig deeper into the stocks suggested by the magic formula and build a more concentrated portfolio than the ones suggested by the formula alone. Such a portfolio will have greater chances of achieving a better return than simply using the formula.