In this week’s Five Minute Read, we take a look at mechanical investing with Joel Greenblatt’s The Little Book That Beats The Market.
Joel Greenblatt is an American hedge-fund manager, author, and academic. He is most famous as the founder and managing partner of Gotham Capital, a hedge-fund that saw 40% annualized returns over 20 years.
Greenblatt is also a co-founder of the Value Investors Club, an exclusive online investment forum limited to 250 members who are chosen based on prior performance. The forum allows members to post between two and six investment ideas every year, and awards cash prizes for the best performers.
Greenblatt currently teaches at Columbia Business School. He has authored three books on investing – You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits (1996), The Little Book That Beats the Market (2006), and The Big Secret for the Small Investor: A New Route to Long-Term Investment Success (2011).
The Little Book That Beats the Market: An Overview
Greenblatt set out to write this book in a way that even a child could understand it… and that’s apparent from the get-go.
Each chapter acts like a little story, with examples that an infant could easily comprehend. That can be charming at times (especially if you’re brand new to investing), but at other times it can sound slightly patronizing. Still, Greenblatt succeeds in getting his points across in a no-nonsense and straightforward way.
Greenblatt assumes no prior knowledge of the stock market or investing. He even borrows Benjamin Graham’s now famous example of Mr. Market to ensure everyone reading has a good idea of the basic mechanics of the stock market before moving forward to the main crux of his argument.
That argument is all contained in chapter five, where the author explains his simple method for achieving outsized investment returns.
Essentially, Greenblatt likes to invest in companies with two characteristics:
1) A high earnings yield.
2) A high return on capital.
A High Earnings Yield
When we talk about earnings yield, we’re talking about how much money the company makes, relative to the stock price. This is represented in the world of investing as the price-to-earnings ratio (or P/E ratio).
The P/E ratio is a quick glance way that some investors use to see how expensive or cheap a stock is – the idea being that a lower P/E ratio equates to a cheaper stock.
Company A stock is valued at $200 and they earn $20 per share. Their P/E ratio is 10.
Company B stock is valued at $100 and they earn $20 per share. Their P/E ratio is 5.
In the most simplistic terms this means that Company B is the better value of the two stocks.
Disclaimer: P/E ratios don’t take into account any further growth and are limited in what they can tell us about stocks.
A High Return On Capital
Greenblatt goes on to explain that just finding cheap companies is not enough – we also want to be invested in quality businesses.
For this, we look at a business’s return on invested capital. A company with good management and a valuable product or service should be able to generate more money for every dollar that is invested in the business.
Both Company A and Company B invest $1 million in a new factory to manufacture their products.
Company A makes $300,000 in the first year that the factory is in operation.
Company B only makes $200,000 in the same year.
Company A has a made more money off that $1 million investment and therefore has a higher return on invested capital.
The Magic Formula
Greenblatt maintains that by combining these two elements you can compile a list of the best businesses to invest in. He even set up a website that will do all this hard work for you.
Once you have that list, all you have to do is invest in those businesses and hold them for one year. After that year, you should sell all those investments, run the formula again, rinse and repeat forever.
Greenblatt goes on to demonstrate how this formula would have performed in the past and shows how it greatly beats the S&P 500 over the course of 16 years (hence the title of the book).
It must be noted that several studies posted online have tried to replicate Greenblatt’s results, and though some of them did manage to beat the market, none managed to get the same outstanding results.
Should You Buy This Book?
At Rubicoin, we believe that you should invest in businesses that you know and believe in.
That philosophy pretty much flies in the face of what is proposed in The Little Book That Beats the Market. According to Greenblatt’s “Magic Formula”, you don’t even have to know what a company does in order to invest in them – we’re not so keen on that idea.
However, some people claim that this is one of the best investment books out there. We’re also eager to educate people about the stock market in general, and The Little Book That Beats the Market does have plenty of good information in there for someone who is just getting into investing.