The Little Book That Still Beats the Market Summary
One Paragraph Summary Who hasn't dreamt of making a fortune on the stock market without having to trust any banksters or self-proclaimed investment gurus? In his book, Joel Greenblatt teaches us everything we need to learn to become a successful investor.
The Little Book That Still Beats the Market
A book by Joel Greenblatt
By writing this book summary, I learned the following three things:
- One can identify excellent investment opportunities
- Having a magic formula doesn't guarantee success
- If you do not want to handle your investments just buy index funds
Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.―Joel Greenblatt
Wouldn't it be great if we could earn above-average returns on the stock market without having to trust any banksters? In his book The Little Book That Still Beats the Market Joel Greenblatt will teach us his formula, which allows us to do just this.
Most of us do not know how the stock market is working. And because we think it is complicated to understand the markets, we turn to financial experts for advice. In the end, those professionals will convince you to invest in one of their financial products.
Financial experts need to make money themselves; therefore, the fees usually are quite high, for example, if you buy a mutual fund.
If you do not want to learn about investing, it is better to avoid mutual funds and invest in index funds instead. The fees of index funds are much smaller than those of mutual funds because you do not have to pay the fund managers.
But if you want to get the best return on your investment, there is no way around learning to invest in the markets yourself. Fortunately, Joel Greenblatt has done the hard lifting for us and shows us a step-by-step approach on how we can beat the markets. The best thing about his formula is that everyone can learn it.
All we need to be successful in the markets is his formula and a long-term investment horizon.
The stock market is not rational. You cannot expect that the price of a stock reflects the fair values of a company. Sometimes a stock is cheap, and on other days it is expensive.
Benjamin Graham, an investment legend and author of The Intelligent Investor, compares the market with a person suffering from enormous mood swings. Sometimes this person feels very optimistic about his companies and is only willing to sell shares of his companies for very high prices. On other days this person feels rather pessimistic about the future of his companies. On these days, he sells his shares at very low prices.
If you invest wisely, you will find a way to buy shares when he feels pessimistic and sell shares to him when he feels optimistic.
Joel Greenblatt shows you how you can do precisely this.
A company has an actual value. But this value is seldomly reflected by its stock price. To make a profit on wall street, you have to ensure to buy shares of the company when the price is below its actual value and sell your stocks when the price is above the correct value.
How can one find the actual value of a company?
You need to look at two numbers to find a company's value: the earnings yield and the return on capital.
To calculate the first number, the earnings yield, you need to divide the earnings before interest expenses and tax (EBIT) by the enterprise value (EV). Do not use the price per earnings ratio (P/E) for the magic formula.
The second number, the return on capital (ROC), is calculated by dividing the after-tax profit by the book value of invested capital.
The book value of invested capital is the sum of all the money invested in the company.
The ROC tells you how good the company is at generating profit for its investors. Joel Greenblatt considers anything above 25 % to be a good number.
If you look for companies that have a high ROC and a low share price, you can buy undervalued shares.
The magic formula combines the earnings yield and the return on capital, which will allow you to invest your money in the best companies of a particular market.
Say you want to invest in the NASDAQ. To find the companies you want to invest in, you need to make two lists. Firstly you would compile a ranking of all companies listed on the NASDAQ by their ROC. The company with the best ROC would be in position 1.
Then you compile a second ranking of the same companies by their earnings yield. Put the company with the best earnings yield in position one.
In the third and last step, you combine the two lists into one ranking by adding the ranks of each particular company. For example, a company listed in position ten on the ROC list and on place 18 on the earnings yield list will get an overall score of 28.
Now invest in the companies that have the best ranking in the combined list: the companies with the lowest sum of ROC position and earnings yield position.
If you had invested in the 30 best stocks that the magic formula revealed between 1988 and 2004, you would have generated an average return of 30 % per year. Compare this to the market average of 12 percent per year.
We just learned that the magic formula, as outlined by Joel Greenblatt, can be a profitable investment strategy.
The question that arises is if there is such a simple formula that can beat the market average, why doesn't every financial expert use it?
The answer is that sometimes the magic formula will deliver below-average returns. In 25 % of all full-year periods, the method will generate worse returns than the market average. Occasionally the magic formula performs worse than an index fund for two or three consecutive years. As a financial professional, this is hard to sell to your clients. After a prolonged time of below-average returns, the client will have fired his financial advisor.
To avoid risk, the author advises not to invest in companies that are too small. A company you consider to invest in should at least have a market value of $50 million.
It is also a good idea to have 20 to 30 stocks in your investment portfolio and to invest in different industries.
Although over the short term Mr. Market may price stocks based on emotion, over the long term Mr. Market prices stocks based on their value.―Joel Greenblatt
Comparing the stock market with a crazy person shows boldly and straightforwardly that the market is seldomly reflecting the actual value of a company. With this knowledge comes the insight that there are from time to time opportunities to find undervalued stocks in a particular market.
The magic formula presented by Mr. Greenblatt is a tool that lets us discover those investment opportunities without having to trust self-proclaimed financial experts.
Maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors.―Joel Greenblatt
Now that we have a magic formula that shows us which stocks to invest in, there is only one thing left to have success on Wall Street: we need to execute our new found investment process.
Joel Greenblatt told us in his book that financial professionals cannot use the magic formula because the results the method generates are often below the market average. For two or three years in a row, the profit made with the recipe will be worse than that of a plain index fund.
Imagine you start investing with the formula tomorrow, and in two years, all your efforts will have shown below-average returns. Wouldn't it be tough to stick to the method? All the effort for below-average returns?
I think this is the biggest issue with the magic formula; you have to be mentally able to execute it over many years, even if you might see meager results.
In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.―Joel Greenblatt
Joel Greenblatt is a financial expert himself, but he tells us that we are better off to trust our abilities to learn than to trust an investment guru.
If you think executing the magic formula and maintaining a portfolio on your own is too burdensome, then his recommendation is just to buy index funds.
This advice is the same as in the Playing with F.I.R.E..
If you only want to read one book about investing in the stock market, Joel Greenblatt's book is the one you want to read. In this little book, you will find everything you need to learn to build and maintain your stock portfolio.
But keep in mind that following the strategy outlined in the book is not easy for everyone.
- Learn to invest in the stock market, as this will give you the best returns for your capital
- Avoid self-proclaimed financial experts, as they often make mistakes themselves
- Do not trust stockbrokers with your investments
- Choose index funds over mutual funds, because the fees are lower
- Learn to invest in the markets yourself if you want to maximize your profits
- Buy when the market offers shares as a discount and sell when the market is overpriced
- Use the magic formula to find the best candidates for your portfolio
- If you use the magic formula, ensure that you will stick to it in the good and bad years
- Use the tax laws intelligently to maximize your profit
- Invest in at least 20 stocks of big companies
- Invest in different industries
Read more about Joel Greenblatt on Wikipedia.
If you are interested in Greenblatt's method you should have a look at the Magic Formula Investing website.
If you liked reading The Little Book That Still Beats the Market Summary, you should also read the Rich Dad, Poor Dad Summary.