Review: The Little Book That Beats The Market

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2 forAfter thoroughly enjoying John Bogle’s The Little Book Of Common Sense Investing, I decided to go back and pick up the first book in the series, Joel Greenblatt’s The Little Book That Beats The Market.

I was hoping for a similar tone as Bogle’s book, which was basically a gentle walkthrough of the investment philosophy behind putting one’s money in low-cost index funds. In a way, I got exactly what I wanted – this book does walk gently through an investment philosophy. Greenblatt has a storytelling tone that’s maintained throughout the book, and this writing style, coupled with the book’s brevity, makes The Little Book That Beats The Market a nice little read.

The real question is whether or not a short book written in a conversational tone can really bring anything to the table for the individual interested in personal finance issues. Is The Little Book That Beats The Market really worth a read for the average person? Does it present a coherent, comprensible, and easy to follow investment philosophy?

Walking Through The Little Book That Beats The Market

This book is ostensibly divided into thirteen chapters, but the chapters are highly story-based (Greenblatt likes to weave a good tale) and they flow together quite a bit. Some of the chapters make really profound points, while other chapters introduce only the most fleeting of concepts. In the end, it makes the book not feel very dense at all.

Chapter 1
The Little Book That Beats The Market opens with a simple story about a boy selling bubble gum on the playground. The author and his son attempt to place a value on the business. In the end, it’s made clear that putting a value on a business is the key to investing in individual companies. Very simple stuff to open the book.

Chapter 2
The meat begins here, with an overview of risk-free (or nearly risk-free) investment opportunities. The under the mattress idea earns no interest at all and is thus the worst investment choice. Better options include a savings account (insured by the FDIC up to $100,000) and treasury bonds (backed by the US government) which can earn up to about a 6% return (right now, both earn about 5%).

Chapter 3
Stocks are gently introduced in this chapter as being small portions of companies that you can purchase that entitle you to a portion of the proceeds of that company. Obviously, stocks of valuable companies are valuable themselves – 1% of Microsoft is far more valuable than 1% of Joe’s Chicken Shack, for example. From there, however, it starts to get tricky – in order to determine if a stock is a good investment, you have to know what the future of the company looks like, and that requires some significant prognostication.

Chapter 4
Here, Greenblatt uses Benjamin Graham’s concept of “Mister Market” very effectively. Imagine that you’re the co-owner of a business with a crazy fellow called Mr. Market. On any given day, Mr. Market will offer to buy your share of the business from you at a certain price or sell you his business at that very same price. However, depending upon his whims, Mr. Market’s offers may radically change from day to day. Naturally, you’ll look to buy when you think Mr. Market’s price is far lower than what you think the business is worth, and look to sell when his offer is much higher than what you believe the business to be worth. This is exactly how the stock market works – at any time, you can either buy or sell a stock at a given price (or not do anything at all). If that price is much higher than what you think it’s worth, you should sell; if it’s far lower than what you think it’s worth, you should buy. But how do we have any idea what the stock of a given company should be worth?

Chapter 5
Some reviews of this book complain that it really only has two ideas in it, and both of those ideas are in this chapter. In a way, this criticism is correct – if you’re already knowledgeable about investing, this chapter contains the essence of this book’s investing philosophy, and it really only boils down to two things, and these two things seem incredibly simple. First, a higher earnings yield is better than a low one – a company that earns a lot compared to the price of a share is good (this is otherwise known as the P/E ratio – the lower the P/E ratio, the better the deal). Second, companies with a high return on capital are better than companies with a low return on capital. Good businesses are able to do more with their dollars than bad businesses. Combining the two means that you should focus on buying good businesses (with a high return on capital) that are cheap (with a low P/E ratio).

Chapter 6
So what do you do with that idea? Basically, The Little Book That Beats The Market proposes that all you have to do is list all stocks by their P/E ratios (the lower ones at the top) and then list all stocks by their return on capital, then combine those rankings and just invest in the top thirty or so, you’ll make a mint.

Chapter 7
Greenblatt likes to refer to this idea from chapter 6 as his “magic formula,” and here he merely shows that in the past the magic formula has worked like a charm, producing stellar results. In fact, the higher the stock is on the magic formula list, the better the stock’s annualized performance in later years.

Chapter 8
However, there is a catch: in individual years, this “magic formula” often doesn’t do well. It only really shines (and “beats the market”) over the long term. If you’re actually willing to stick with it over several years, through thick and thin, then it will pay off for you. If you’re not willing to do that and just let it ride, then this investing concept won’t necessarily work.

Chapter 9
This chapter basically expands the concepts of earnings yield and return on capital to show how they both indicate important aspects of the company. If a company has a high return on capital, that generally means that that company has great money sense. If a company has a low P/E ratio, that basically means that a company is being traded at a relatively low rate. Combine the two together and you find value.

Chapter 10
This portion is actually rather interesting, but it falls just short of getting too technical. Basically, the author argues that the magic formula works because over time the market tends to be efficient, but at any given time, little pieces are inefficient (some stocks are overpriced and some are underpriced). The magic formula basically looks at the stock market for the last year, looks at two key pieces of information, and tries to find those stocks that are the most underpriced, assuming that over the long haul they won’t be underpriced and will actually go up to the average, which will mean a big gain for the investor.

Chapter 11
Most people have no business investing in individual stocks on their own. A bold statement to make in a book about individual stock picking, but it’s a true one. Basically, instead of just blindly following this formula, Greenblatt actually encourages people to use it merely as one tool in the toolbox – use it as a “first pass” filter to eliminate bad stocks, then just pick from among the top ones from the formula.

Chapters 12 and 13
The book concludes with these two chapters, which basically close up the topic by encouraging most investors to invest in index funds instead of doing individual stock picking, because broad-based index funds return well and individual stock picking, even using this formula, requires a lot more patience and tolerance of short term losses than most people really have.

The Magic Formula In A Nutshell
The book concludes with a multi-page appendix that lays out how to apply the magic formula. Here’s that explanation in a nutshell:

Go to a website that lets you filter stocks by certain criteria (like this one at Yahoo!). Filter for stocks that have a ROA (return on assets) of at least 25%, then rank them according to their P/E ratios, with the lowest at the top. Toss out all stocks with a P/E lower than 5 (something’s fishy there), all utility and financial stocks, and all foreign stocks. Buy five or seven of these stocks a month for five months (or so). When you near a year of owning one of these stocks, if it’s at a loss, sell it when you’ve owned it one day less than a year and if it’s a gain sell it when you’ve owned it one day more than a year (playing games with the capital gains tax, basically). Then reinvest what’s left. Keep doing this for at least five years. That’s it!

Buy or Don’t Buy?

The Little Book That Beats The Market is a splendid introduction to fundamentally sound individual stock picking. The real key word here, though, is introduction – this book literally starts at the point of kids on the playground selling bubble gum (no joke) and builds from there to explain the fundamentals of the stock market in a very warm tone.

In fact, the entire book can be summed up in the following sentence: The Little Book That Beats The Market sums up how the stock market works and encourages investing based on return on capital and earnings yield. Really – that’s almost the entire meat of the book. That’s not necessarily a bad thing – the content here wouldn’t overwhelm anyone – but if you’re looking for a very thorough investment guide, this one probably isn’t it.

On the other hand, if you’ve ever thought about investing in individual stocks but have no idea what to do, The Little Book That Beats The Market is an excellent place to start. I would recommend it as the first book to read on the topic, to be followed by Jim Cramer’s Real Money as a follow-up if you’re really interested in sticking your toes in. In other words, read this book if you’re thinking about individual stocks at all, but don’t know where to start.

Even if you’ve decided against investing in individual stocks (I’m still riding the fence, myself), this book is worthwhile because it explains, in very simple and conversational terms, the basics of how to evaluate stocks and how to invest in them to maximize your dollar. It never hurts to understand the topic.

The Little Book That Beats The Market is the thirty-sixth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.

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11 thoughts on “Review: The Little Book That Beats The Market

  1. Hey Trent,

    If you go over to “All Financial Matters” they have a running portfolio using the methods outlined in the book … the portfolio is up 25%+

  2. I carved out 20% of my IRA for this strategy. Only 4 month track record currently but it’s been outperforming the closest benchmarks (Small Cap Value) during this time. The key is free trades — without free trades, commissions will eat cut into your profits where you’d probably underperform. My numbers since the start of April in comparison to the various Small Cap Value options:

    Magic Formula – 13.7%

    DSV SPDR DJ Wilshire Small Cap Value – 5.90%
    IWN Russell 2000 Value Index – 0.88%
    JKL Morningstar Small Value Index – 2.81%
    IJS S&P SmallCap 600 Value Index – 7.13%
    VBR Vanguard Small-Cap Value (MSCI) – 4.49%
    RZV S&P SmallCap 600 Pure Value – 3.40%

  3. A better title would be _The Little Book that Used to Beat the Market_. Or, rather, that will be the title soon enough.

    While I am all for using solid fundamentals to identify potentially undervalued stocks, the caveat you must keep in mind is that any automated stock selection process (which this qualifies as) will deteriorate over time as more people use it (and the more automated the process, the more quickly that will happen). As more people utilize this method, the inefficiency in market valuation that it exploits will shrink and the returns will diminish.

    Don’t believe me? Check out O’Shaughnessy’s _What Works on Wall Street_. In that book, the author surveys a number of stock-picking methods and crowns Ken Fisher’s “Low Price-to_Sales Ratio Stocks” as the “best” method. The only problem is that this stock picking method is old-hat and doesn’t really work anymore. Ken Fisher said so himself in his book _The Only Three Questions That Count_.

    While I have used Greenblatt’s website to generate investment ideas (which require further investigation), I would be really apprehensive about robotically buying stocks picked by a stock screen. That’s just asking for trouble.

    Finally, if you want a real book on stock investing, pick up Benjamin Graham’s _Intelligent Investor_. Published in 1949 and still relevant to this day! If it bores you or you can’t understand it, then you are probably not ready to invest in individual stocks. If you spend the time to understand Graham, you’ll see that many of the concepts he puts forth over 50 years ago are being used and quoted by the investment writers of today. I guarantee that it will bring more recent investing texts into a different perspective.

  4. My philosphy is the reverse — robot is better. Unless you are Warren Buffet with direct influence over the company stock you buy, it’s just random luck whether you outperform or underperform the market. (Case in point, Monkey versus Cramer where the monkey randomly choose Yay/Nay on Cramer’s picks beats his performance — or previous studies on dartboards beating analysts.) What you can’t manage in investing smarts, you can make up by keeping costs down and sticking to a disciplined system. Magic formula is pretty much indexing at a micro-level. Instead of 1000 small cap value stocks, the computer picks ~30 small cap value stocks. Fewer picks gives you the possibility to isolate higher returns (deep value) but at the cost of higher risk.

  5. over at yahoo groups, there have been several discussions around how good this “magic formula” really is. I have been a lurker there for at least a year now. Seeing many portfolios hit the 20%+ range, I started my own model portfolio at the beginning of the year for 5k. I am up 32% as of today, even with a couple of stinkers on the list. As Toby mentioned above, it may be magical only for a few more years. I can’t predict that, but seems to work for me in the short term and from what I’ve heard on the forum, it has been working for others also. You can view results here from someone who has done this for 1 year and kept good notes: http://justadrone.blogspot.com/
    I would agree with Toby in mentioning that this should not be looked at as a fool-prrof way to make money in stocks. After screening, a prudent investor should check out the background of the companies before putting down any money. Magic Screen + Personal Research appears to be the best way to go.

  6. The magic formula idea suffers from the same problem that all betting systems do, you have to have an infinite bank to be able to survive the long losing run that will inevitably come and wipe you out. Any betting formula, no matter how simple or arcane, is dependant for its sucess or failure upon the size of your bank. Best to always remember that.

    BB

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