Finance and AccountingInvestment Strategies
Title: The Little Book That Still Beats the Market
Author: Joel Greenblatt
Year: 2010
Category: Investment Strategies
Introduction
Joel Greenblatt’s “The Little Book That Still Beats the Market” is a transformative resource in the world of investment strategies. Capturing the essence of how to approach the stock market systematically, Greenblatt presents a concept that’s both simple and profoundly effective. At the heart of the book is the Magic Formula, a two-step quantitative approach designed to yield extraordinary returns. The book elucidates financial principles through clear analogies, practical examples, and actionable steps.
1. Understanding Market Efficiency and Stock Valuation
Major Point: Efficient Market Theory
– The Efficient Market Theory posits that all known information about investment securities, such as stocks, is already factored into the prices, making it impossible to consistently achieve higher returns.
Example: Greenblatt challenges this theory, discussing how emotions and misinformation can lead to market inefficiencies and opportunities for savvy investors.
Action: Be skeptical of the assumption that stock prices always reflect their intrinsic value, and look for opportunities where pricing anomalies occur due to irrational market behaviors.
2. Concept of Earnings Yield and Return on Capital
Major Point: Two Key Metrics
– Greenblatt introduces two critical metrics: Earnings Yield and Return on Capital. Earnings Yield is defined as earnings before interest and taxes (EBIT) divided by enterprise value, providing a perspective on how much the investor earns relative to the cost.
Example: If a company’s EBIT is $500,000 and its enterprise value is $5,000,000, the Earnings Yield is 10%.
- Return on Capital is calculated by EBIT divided by net working capital plus net fixed assets, an indicator of how effectively a company generates profits from its capital.
Action: Use financial statements to determine these two metrics for companies of interest. Focus your investments on companies with high Earnings Yields and high Returns on Capital, indicating potential undervaluation and operational efficiency.
3. The Magic Formula
Major Point: Combining Metrics in the Magic Formula
– The Magic Formula combines the rankings of earnings yield and return on capital to identify stocks with both high profitability and attractive pricing.
Example: Consider Company A with an Earnings Yield ranked 50th and Return on Capital ranked 70th, whereas Company B has an Earnings Yield ranked 30th and Return on Capital ranked 40th. Company B would be a priority as the total rank (30+40=70) is lower than Company A’s (50+70=120).
Action: Rank a list of potential investments by each measure, combine rankings to identify the best opportunities, and periodically rebalance the portfolio based on this method.
4. Actionable Investment Strategy
Major Point: Portfolio Diversification
– Greenblatt recommends diversifying investments to mitigate risk. His approach advises owning 20-30 stocks picked using the Magic Formula.
Example: If one constructs a portfolio by picking 25 top-ranked stocks based on the Magic Formula, this diversification spreads risk even if a few of them underperform.
Action: Build and maintain a diversified portfolio of 20-30 stocks selected using the Magic Formula. Regularly review and adjust these selections to stay aligned with the investment strategy.
5. Mechanics of Rebalancing the Portfolio
Major Point: Annual Rebalancing
– The book advises rebalancing the portfolio yearly, recalculating the Magic Formula scores to adjust holdings while minimizing transaction costs.
Example: A portfolio created in January 2020 should be reassessed in January 2021. Sell stocks whose rankings have fallen and purchase new top-ranking stocks as per the latest Magic Formula application.
Action: Set a systematic schedule for reviewing and rebalancing your portfolio yearly to ensure ongoing alignment with the Magic Formula.
6. Long-term Investment Perspective
Major Point: Patience is Key
– Greenblatt emphasizes the importance of long-term thinking, noting that the Magic Formula might underperform in the short term but generally outperforms over three to five years.
Example: A study in the book shows that a $10,000 investment following the Magic Formula consistently outperforms the S&P 500 over a ten-year period, despite some years of underperformance.
Action: Commit to a long-term investment strategy and avoid reacting to short-term market fluctuations. Stick with the Magic Formula for at least three to five years to realize its full potential.
7. Handling Market Emotions
Major Point: Counteracting Emotional Decisions
– Greenblatt warns against letting emotions drive investment decisions, which can lead to buying high and selling low—contrary to optimal strategy.
Example: Emotional investors might sell a stock during a market dip out of fear, missing out on potential long-term gains when the price rebounds.
Action: Maintain discipline by strictly adhering to the Magic Formula, even during periods of market volatility. Avoid making knee-jerk decisions based on short-term market movements or emotional reactions.
8. Practical Steps and Tips
Major Point: Implementing the Magic Formula on Your Own
– Greenblatt provides a step-by-step guide for investors to implement the Magic Formula without needing advanced financial knowledge.
Example: Using free online resources and publicly available financial data, investors can easily calculate Earnings Yield and Return on Capital for thousands of stocks.
Action: Utilize websites, like the author’s own and others offering financial data, to compute the necessary metrics. Apply the Magic Formula method consistently across your selected universe of stocks.
9. Historical Performance and Validation
Major Point: Empirical Evidence
– Greenblatt supports his claims with historical performance data, demonstrating how the Magic Formula has historically beaten market averages.
Example: Back-tested data and performance summaries in the book show average annual returns significantly higher than those of major indices.
Action: Analyze historical data from reliable sources to reinforce confidence in the Magic Formula. Use historical performance as a benchmark and motivation to follow the prescribed methodology.
10. Advanced Considerations
Major Point: Adaptations and Fine-Tuning
– While the Magic Formula is straightforward, advanced investors might fine-tune their approach by incorporating additional metrics or adjusting for market conditions.
Example: Some may combine the Magic Formula with other valuation methods, such as discounted cash flow analysis, for a more comprehensive assessment.
Action: As you gain experience, consider integrating other valuation techniques that complement the Magic Formula, enhancing your investment analyses and strategies.
Conclusion
Joel Greenblatt’s “The Little Book That Still Beats the Market” offers a blueprint for achieving superior returns through a disciplined, systematic investment approach. By focusing on high Earnings Yield and superior Return on Capital, investors can leverage market inefficiencies to their advantage. Key actions derived from the book include embracing long-term perspectives, following a structured rebalancing schedule, diversifying investments, and avoiding emotional decision-making. Through practical examples and actionable steps, the Magic Formula empowers both novice and seasoned investors to outperform the market consistently.