Review: The Little Book That Makes You Rich

Little BookThe Little Book That Makes You Rich is the fourth in a series of investment books that each strive to explain in layman’s terms a specific investment strategy. I reviewed the first three, each of which I liked:

The Little Book That Beats The Market by Joel Greenblatt focuses on “magic formula” investing, where a small set of criteria are used to select stocks that represent strong, undervalued businesses
The Little Book of Value Investing by Christopher Browne focuses on the value investing philosophy – seeking out strictly companies that seem to have a business value that exceeds their stock’s value
The Little Book of Common Sense Investing by John Bogle focuses on index investing, or investing in low-cost mutual funds that own broad swaths of stocks and aren’t actively managed

All three did a good job of spelling out their specific investment strategy in easy to understand terms, so I was quite excited to read this fourth entrant in the series. The Little Book That Makes You Rich by Louis Navellier takes on growth investing – that is, finding and buying specific stocks that show the signs of growing rapidly.

It’s a great strategy, but it does have some serious risks associated with it. How will you know whether the stock is a rocket or a dud that fails to launch from the pad (is it or, in other words)? Also, how will you know when to sell the stock – is it Enron in 1997 (too early), Enron 2003 (too late), or Enron 2000 (just about right)?

I cracked open the book, eagerly hoping for a great layman’s explanation of the growth investing philosophy and how it can work for an ordinary joe investor like me.

Peeking At The Little Book That Makes You Rich

Chapter One: Let’s Start At The End
Navellier, right off the bat, identifies eight factors he uses to identify a stock that’s about to show stellar performance:

1. Positive earnings revisions
2. Positive earnings surprises
3. Increasing sales growth
4. Expanding operating margin
5. Strong cash flow
6. Earnings growth
7. Positive earnings momentum
8. High return on equity

These signs all point towards a healthy and robust company. Navellier illustrates this by showing that stocks that rank among the top in each of these categories individually consistently beat the market, but also notes that just being strong in one category isn’t enough because the market changes rapidly. One should diversify, finding stocks that are strong in all eight factors, so when one particular element becomes “hot,” you can ride it, but when that element cools off, it doesn’t kill your whole portfolio.

Chapter Two: Counting On Growth
The admonition of this chapter can be summed up in two words: trust numbers. Navellier firmly believes that numbers don’t lie and that one should follow in the direction that they lead you. He uses several examples for this in various environments, but my favorite was when he mentioned Moneyball.

For those unfamiliar, Moneyball relates the story of Billy Beane, the general manager of the Oakland Athletics, who was the first to strongly apply deep statistics to the art of selecting a major league roster. He was also constrained by a relatively small budget. Yet, largely because of this statistical approach, Oakland became one of the best teams in baseball for most of the last decade even though their budget was tiny.

Chapter Three: Emotional Rescue
Hand in hand with the idea of trusting the numbers comes the idea of not following your emotions. Much like the previous chapter, this one provides a huge number of examples of how emotional and psychological traps stand in the way of good investing strategies. This is excellent advice for any investor to read, but it’s often repeated in investing books. In short, don’t ever get led around by your emotions when investing – you’ll lose every time.

Chapter Four: Revise, Revise, Revise
This chapter, and the seven that follow it, focus on the eight signs of a good stock stated in the first chapter. Here, Navellier focuses on earnings revisions, or those times when analysts change their original prediction of how much a company will earn in the coming quarter. Navellier does a great job of illustrating the logic of an analyst here, in that it’s in their best interest to forecast low, so when analysts actually raise their predictions, it’s usually a good sign something’s going on with the stock.

What keeps them from just forecasting low and then raising on every stock that they want to pump up the price on? Basically, it relies on a need to be fairly accurate and match what others are saying – if you’re off in the corner dumping out numbers completely out of whack with the rest of the industry, it won’t be long before you’re ignored and then out of a job.

Chapter Five: Surprise, Surprise, Surprise
The second sign is that of an earnings surprise, in the positive direction, of course. This happens when a company announces earnings that exceed the analyst estimates of what the company will earn in a given period and usually indicates a surging company, one that is often in the throes of growing well. In other words, a stock you want to jump on board with.

Navellier here shows the examples of Apple and Hansen Natural (I actually happen to enjoy both companies’ products, incidentally), both of which exceeded earnings expectations in consecutive quarters. In both cases, the stock showed spikes, providing at least a pair of examples where beating expectations caused a stock to soar. I poked around a bit and found several more in just some trivial research on Yahoo! Finance.

Chapter Six: Sell, Sell, Sell
The third sign is sales growth. Navellier uses a strong comparison between the top 5% of companies in terms of sales growth and the bottom 5% to track how their stocks increase in value over time, with (obviously) the companies with strong sales coming out on top substantially. However, it’s interesting to note that the two sets both peaked and vallied at similar times, meaning that in many cases, the whole market moves, not just a segment of it.

On the flipside, slowing sales growth is a sign that it might be time to sell a stock, even if it’s a giant company. Microsoft and Intel are two examples of this – they’ve both grown so large and sold so much product that there’s literally not much room for the companies to find more sales.

Chapter Seven: Expand, Expand, Expand
The fourth indication of potential strong growth is operating margin expansion. In other words, does a company’s profit increase over time? An increase in profit indicates that the company is growing well and there is no significant competition holding it back from growing even more. Navellier prefers the “operating margin” indicator for profit, which is operating income divided by net sales. Why? This ignores the net income for the company, which is a number that can easily be padded with various accounting tricks – net sales is much harder to play games with.

Again, the flipside is true. If a company shows slowing expansion of profit margin, or even worse, their profit margin is shrinking, it’s probably time to dump the stock. This usually means that there’s competition in the water or else there are no fresh products being sold by the company, both of which are clear signs of stagnation.

Chapter Eight: Let It Flow
The fifth variable is free cash flow, or the money left over after all the bills are paid. Companies with a lot of free cash flow are able to spend it on growing their business, much like people with a lot of money left over after paying the bills are able to invest it and also buy goods to improve their quality of life.

Obviously, growth investors want to seek out companies with nice, fat cash flow. These companies are likely to grow because they can invest the money in themselves, either through improving the company or by buying back their stock (improving its value due to supply and demand of the stock) or even through paying out nice dividends to shareholders.

Chapter Nine: It’s All Variable
The sixth, seventh, and eighth factors are all covered in this chapter: earnings growth, earnings momentum, and return on equity. These are all very simple indicators of growth – earnings momentum is the only potentially confusing one, and it’s merely the idea that a stock should increase its earnings growth each period (a very good sign indeed).

Taken as a whole, these eight factors all point towards companies that are doing very well – if they have strong positives in all of the categories, it’s likely they’re going to be making some serious upward moves in the near future.

Chapter Ten: Know Your Alpha Beta
This chapter explains the stock terms alpha and beta in wonderful layman’s terms, explaining concepts that were previously a bit confusing even to me. Beta, in a nutshell, refers to the change in a stock over a period of time that matches the market. A stock with a high beta moves up and down almost perfectly in time with the rest of the stock market; a stock with a low beta does not. Alpha, on the other hand, refers to the difference between the stock and the market. Basically, beta is the part of the stock that does what the entire stock market does and alpha is the part that’s different.

Thus, an investor looks for a stock with a high positive alpha, because investors want stocks that do well in a down market – stocks that do well in an up market don’t necessarily have much alpha. How do you find these? The best way to do that is to follow stocks and compare how they do versus an index that includes them. For example, if you have a stock in the NASDAQ, compare the stock to the NASDAQ. Watch it over time, each day, and note the difference between how the stock performs and how the market performs. If you find a stock that has many more up days than the corresponding index, you’re probably finding a stock that has a high alpha and is worth investing in.

Chapter Eleven: Don’t Be A Deviant
Here, Navellier talks about the standard deviation of a stock price over the last year. For those not into math, standard deviation refers to the reasonable amount a stock should vary up and down given a set of data (say, the stock’s closing price each day over the last year). If a stock starts moving up and down regularly outside of that standard deviation, it’s getting very volatile and that means it’s probably time to get out of that stock.

Navellier gives a great example of this in the form of eBay, which used to be a very worthwhile stock to own. However, in 2005 and 2006, it fell victim to changes in the S&P 500, which caused the stock to start staggering wildly and eventually start falling as people who ran index funds began selling eBay to keep up with the changes. Using standard deviation, it was clear very near the peak of the stock that something odd was going on – people who knew about the indexing changes were selling, while people who still identified eBay as “hot” were buying, resulting in some crazy one-day swings. Time to bail.

Chapter Twelve: The Zigzag Approach
There are times when some sectors are hot and others are cold, but a few years later those cold sectors might be hot. Take, for example, retail stocks – they do very well when the economy does well and then poorly when the economy is poor and people aren’t buying things. On the other hand, drug companies tend to do reasonably well all of the time and often do particularly well when the economy is slow. Thus, if you own one, it might make sense to own the other one as well – pair a retail stock and a drug stock so that when the economy cycles, you always have a stock that’s doing well.

The real key is to always look for stocks that do well in the factors described earlier, then make sure that you have stocks that pair up well – one zigs when the other zags. This way, your portfolio doesn’t fly high, crash, then fly high again – it grows steadily, ideally at a rate that beats the market soundly.

Chapter Thirteen: Putting It All Together
Here, Navellier discusses how he uses these factors to determine which stocks to buy. In essence, he just pulls out data on the factors he’s interested in and gives them a letter grade in each area, then averages them (giving heavier weight to certain areas at different times) to give an overall letter grade. He the buys stocks with good grades (A and B) and sells stocks with bad grades (D and F). This actually makes some sense – take all of the stocks in the S&P 500, for example, and rank them by each of the eight factors and grade them on each (top 10% getting an A, next 10% a B, and so on), then average the scores and you’d be getting pretty close.

How can one do this? Navellier mentions the tools at Yahoo! Finance and MSN, but also describes the tools at his own site, Get Rich With Growth. I played around with the tool and it seems very glossy and user friendly, but not too heavy on the raw numbers. It’s fun to play with the real data and his tool in tandem, though.

Chapter Fourteen: Quantum Leap
This chapter largely focuses on short-term investors, particularly day traders, but some of the advice is useful for people investing over long periods. For example, the idea of executing limit orders is a good one – if you buy a stock, don’t buy it at the market price, but set a “limit” price, meaning you specify the maximum amount you’re willing to pay for the stock.

Chapter Fifteen: It’s the Economy, Stupid
Navellier focuses on how larger-scale economic and social events can effect the stock market. He uses several examples to illustrate this, including the classic “sell in May and go away” idea which comes about from brokers going on vacation and checking out for the summer, resulting in low trading volumes and an often stagnant stock market.

The one I found most interesting is that consistently since 1900, the second year of a Presidential term (1998, 2002, 2006, etc.) has been poor for the stock market as compared to other years in the term. The strongest? The third year of a term, of which 2007 would be one. Why? The economy tends to boom in the third year of a Presidential term, plus the media tends to turn the focus away from the President and on towards elections and other issues at that time.

Chapter Sixteen: It’s a Small World After All
Here, Navellier indicates that these same principles work for global investing as well, but only in markets with reliable data available, like London and Hong Kong. Don’t try relying strongly on corporate data from the third world, as there is very little accounting regularity there.

I find that the best way to diversify in foreign markets is to just buy an index fund. I don’t mind pondering about dabbling in domestic stocks much because domestic rules and regulations means that their accounting today is tighter than ever and thus more reliable, but in other nations the rules simply aren’t as reliable.

Chapter Seventeen: A Watched Pot Will Boil
The trust the numbers mantra comes up here again. Basically, Navellier encourages investors to spend the time keeping tabs on their stocks – to do the homework, so to speak. This way, when the wind starts to change, you’ll know and be prepared to sell.

The biggest danger is falling in love with your stocks, and that’s a big reason why I don’t invest in individual stocks. My heart often tells me to buy specific stocks of companies that I like because of their practices, like Hansen Natural and Herman Miller, and not because of any sound investing reason. Then, when their product stays the same but the business market changes, my heart will still be tied to the stock – not good. So, for now, I sit on the sidelines and watch the game, happily investing in indexes.

Chapter Eighteen: Lions and Tigers and Bears, Oh My!
As the book winds down, Navellier takes a look at some of the real pitfalls to look out for when investing. He covers bad accounting practices (Enron, for example) and Wall Street hype, among others. Generally, if you see a lot of people hyping up a stock, you should actually avoid it – and the same is true for even the faintest hint of faulty accounting.

Although he doesn’t come out and directly say it, he seems to insinuate that a company that has a lot of “one time charges” is usually doing bad business and should be avoided for the time being. Usually, he says, one time charges are used to cover up other mistakes that a company makes.

Chapter Nineteen: Keep Your Eyes on the Prize
The Little Book That Makes You Rich closes with a chapter largely about optimism. I actually found it to be a great way to close the book, especially since we sometimes seem to live in a world made up of bad news and rabble rousing.

Navellier’s belief is that instead of being negative, look around for signs of positive everywhere you look. Not only is that a good way to invest, it’s an excellent way to live your life.

Buy or Don’t Buy?

The Little Book That Makes You Rich did a very good job of explaining the strategy behind growth stock investing in easy enough terms that a beginning investor could understand what’s going on. If that appeals to you, buy this book. It’s a touch deeper than some of the others in the Little Books series, but not overly so – just enough meat to really keep me interested and get my mind racing a bit.

However, if you’re looking for an “ultimate answer” for investing, you might be better suited looking at a more well-rounded investing book like The Bogleheads’ Guide to Investing.

For me? I was intrigued enough to attempt to find some growth stocks and to track them carefully on Google Finance to see how they do over time. Google Finance flags earnings reports for me so I can see what those look like and also find out if they beat estimates or not, as well as research many of the other “flags” that indicate a growth stock. This was the first book I read that laid out the growth-based strategy clearly enough and in enough detail for me to do that, so I consider it a very good educational read.

I have been thoroughly impressed with the entire Little Books series for investors, and I hope that the upcoming fifth book in the series, The Little Book That Builds Wealth, lives up to the standard.

The Little Book That Makes You Rich is the forty-ninth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.

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