Saturday, May 06, 2006

The Little Book that Beats the Market by Joel Greenblatt

The Little Book that Beats the Market by Joel Greenblatt

If we can’t predict the future earnings of a business, then it’s hard to place a value on that business. If we can’t value a business, then even if Mr. Market goes crazy sometimes and offers us unbelievable bargain prices, we won’t recognize them. P41

If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices giving you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away. P45

The formula starts with a list of the largest 3500 companies available for trading. It then assigns a rank to those companies based upon return on capital… Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield… Finally the formula combines the rankings… The formula looks for the companies that have the best combination (lowest score) of those 2 factors. P54

Put more simply, the formula is systematically helping us find above-avg companies at below avg prices. P79

Is the magic formula picking companies that are so small that few people can really buy them?…Even the smallest of the those 3500 companies still had a market value of over $50M. With that size, individual investors should be able to buy a reasonable number of shares without pushing prices higher. P60

Does this formula work for large cap stocks? Let’s see what happened when we narrowed the group to just the largest 1000 companies – only companies with market values over $1B. The market avg from 1988 to 2004 was only 11.4% per year, and the formula yields 22.9%. p61

While it’s pretty nice that the magic formula can find 30 good companies that Mr. Market has decided to throw away at bargain prices, what if it can’t? What if Mr. Market wised up a bit and stopped offering us those few incredible bargains?… If we can’t for some reason buy the top 30 ranked stocks, it’s no big deal. Buying the next 30 should work pretty well also. So should the next 30! In fact, the whole group (top decile) of top-ranked stocks appears to do well (top decile performance was 17.9% during 1988-2004 vs. 11.4% for overall market). P65

Since the magic formula is merely a ranking, by definition, there always have to be stocks that rank at the top. Not only that, because the formula appears to work in order, we’re not limited to just the top 30 stocks. P65

How can this strategy keep working after everyone knows about it? In fact, on average, in 5 months out of each year, the magic portfolio does worse than the overall market. But forget months. Often it doesn’t work for a full year or even more…For full year periods, the formula failed to beat the market avgs once every 4 years. 18% of the time, the formula did poorly for 2 years in a row… So what’s the point? The point is that if the magic formula worked all the time, everyone would probably use it. If everyone used it, it would stop working. That’s why we’re so lucky the magic formula isn’t that great. P71-3

So Greenblatt is saying, you’re going to lose money, but stick with me for over 2 years if not more and then you may see a turnaround. And if you bail out, then you are a quitter, and you’re helping everyone else who sticks to this formula. Hmm, sounds like a lot of faith. You just gotta believe. OK, I’ll skip ahead otherwise, this would be full of crap.

Following the formula for 3 years in row (during any random 3 year period), the formula beat the market averages 95% of the time (160 out of 169 random 3 year periods). But that’s not all. Over 3 year periods, you would have never lost money! You would have made money 100% of the time (169 out of 169). The worst return was an 11% gain! Compare that to a worst loss of 46% for the market. These results are for the largest 1000 companies. When looking at the largest 3500, every 3 year period tested (169 of 169) beat the market averages. P 91-2

Why does this work over 3 year periods? In short, over time the interaction of all these things – investors searching for bargains, companies buying back their stock, and the takeover or possibility of a takeover – work together to move share prices toward fair value. Sometimes this process works quickly, and sometimes it takes several years. P98

The formula works far better with smaller and medium capitalization stocks than with larger stocks. This shouldn’t be surprising. Companies that are too small for professionals to buy and that are not large enough to generate sufficient commission revenue to justify analyst coverage are more likely to be ignored or misunderstood. As a result, they are more likely to present opportunities to find bargain priced stocks. P148

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1 comment:

Hendrik Oude Nijhuis said...

I have read hundreds of books on value investing, Warren Buffett etc, and publish investment tutorials on value investing myself. I highly recommend Greenblatt’s ‘the little book that beats the market’. It could be one of your best investments ever!

Success in investing,
Hendrik Oude Nijhuis