Here’s a summary of the book, “The Little Book That Beats The Market” by Joel Greenblatt, a hedge fund manager, investor, writer and professor, most notably known for Magic Formula Investing - an investment strategy he outlines in this book
Right off the bat, Joel Greenblatt, the author let’s you know that most professional investors and money managers are not going to help you beat the market. You can try going with a money manager, but most of them are only trained to sell you a particular investment product. You can try going with a mutual fund, but trying to pick mutual funds that will outperform the market is like having a monkey throw darts on a list of stocks. It involves quite a bit of luck (also cleaning equipment if the monkey chooses to fling poop instead of darts). If you are one of those rich farts that uses gold bars as bookmarks, you can try going with a hedge fund but the 2-20 fee structure will kill your returns. And if you are a middle-income fart that uses regular bookmarks as bookmarks, you can try going with an index fund but they will only give you the market’s average return minus taxes and costs.
If you want to beat the market, you’re going to have to do it yourself. How can you do that? By finding out what companies are worth and then trying to buy them for less than that. And that’s the essence of value investing, bottled in one small sentence.
Sure, you can save your money by sticking it under a mattress. But it’s not going to grow. In fact, it’s going to lose value due to inflation. You can grow your money by sticking it in a bank. The bank will take your money and lend it to companies. The bank will give you a small interest rate and make coffins full of fat stacks in the process. Or you can bypass the bank and lend your money directly to companies by buying bonds, make those fat stacks yourself. Your money or investment will grow at a higher interest rate, but that also comes with a higher risk of losing your money. So what is a risk-free investment? Well, the safest investment in the world is the 10-Year Bond issued by the US Government. So any investment worth your time must give you a higher interest rate than the 10-Year US Bond. Since the interest rate on the 10-Year US Bond is what investors in the market are demanding for a risk-free investment, therefore it follows that an investment with risk must yield higher than that.
If you haven’t rage quit this window by now, you’re in luck. Because the author suggests that the best option to grow your money is buying shares in a company. This entitles you to a portion of that company’s future profits. As discussed, that portion must be higher than what you’d earn on a 10-Year US Bond. How on earth do you calculate that? Earnings Yield.
Earnings Yield = Earnings Per Share / Market Price.
The earnings yield of any investment must be more than the interest rate on the 10-Year US Bond. The book argues that companies with a high earnings yield are available for purchase at cheap prices relative to what they’re earning. In short, a high earnings yield gives you a bigger portion of the company’s profits at cheaper prices. Because of this, earnings yield is used as gauge of measuring if the company’s stock price is cheap or expensive. Higher the earnings yield, cheaper the company. But a company trading at cheap prices, doesn’t always stay that way because over the long term prices will rise to where they should be. And as prices rise, earnings yield will drop. Yield. Yield. That’s a very weird word if you keep repeating it over and over again. Yield.
Alright, now that we’ve established that, let’s go back to that small sentence. Finding out what companies are worth and then trying to buy them for less than that. But if you can find out what a company is worth, then so can your neighbour and the entire block, which makes it just a tinsy bit difficult to buy the company for less than that what it’s worth. Lucky for you, stock prices fluctuate wildly over short periods of time. However, the worth of the underlying company does not fluctuate as much. This provides you, your neighbour and indeed, the entire block with opportunities to buy shares at prices below the worth or value of the company and sell shares at prices above the value of the company. But having a big margin of safety is always better. A margin of safety is buying shares when they are trading at way, way below the value of the business. This is a good idea because at the end of the day, you’re only human. And as unfortunate as that sounds, it means that you will make errors and encounter unexpected scenarios that affect the underlying company. A margin of safety helps you mitigate that risk. Let’s take a moment to say thank you to the margin of safety, the unsung hero of investing.
The stock market that fluctuates wildly over short periods of time is that same stock market that lusts after growth. It stares at growth in profits in very much the same way a broke college student stares at ready-to-eat noodles. And very much like the broke college student with his noodles, the stock market pounces on every company that shows consistent high growth in profits. But what leads to a high growth in profits? If you follow the book, it’s a high return on capital.
Return On Capital = (Net Income - Dividends) / (Equity + Debt)
The book argues that companies that earn a high return on capital have the opportunity to reinvest profits at a high rate of return. This leads to a high rate of growth. And you know what that means. That means the stock market falling over itself to throw money at the company’s stock. Companies with a high return on capital are also likely to have a special advantage of some kind that keeps competitors from destroying the ability to earn above-average profits. Higher the return on capital, better the company.
Now, here is where the book dives into the magic formula of investing. No, it doesn’t involve pulling bunnies out of a hat. And no, it doesn’t involve carrying around a never ending chain of handkerchiefs. However, it does involve buying good companies at bargain prices. What are good companies? Companies with a high return on capital. What are bargain prices? Companies with a high earnings yield. What do you get when you put those two things together? Magic. Or at the very least, market beating investment results.
To substantiate its claims, the book also offers some proof that the magic formula works. Consider the 3,500 largest publicly traded US companies. Rank these companies separately by return on capital and earnings yield. Combine these rankings. For example, a company with 32nd highest return on capital and 56th highest earnings yield would rank 88th (32+56) on the combined rankings. Over 1988-2004, owning a portfolio of 30 highest ranked stocks according to these combined rankings would’ve returned 30.8% per year whereas the S&P 500 returned 12.4% per year. Those are some impressive numbers right there.
What the magic formula really does is that it ranks stocks in order of quality. Hence, it will continue to work so long as the market continues to offer stocks. And it doesn’t sound like the market is going to run out of stocks any time soon. This magic formula works for big as well as small companies, and doesn’t appear to be based on sheer luck or random chance. However, too much of a good thing can be bad. So let’s throw in some bad news. The magic formula only works over the long term. It underperforms the market once every four years. However, as the tables of data in the book corroborate, over a long term time horizon the magic formula certainly beats the market.
By now, you should be asking, “If this new fangled formula is so good, why isn’t everyone already using it? Huh? Huh? Check-mate, mister wall street.” And even if you aren’t asking that, the book has an answer anyway. Most people will not stick to a strategy that will sometimes underperform the market. They will simply abandon the strategy. This is where the author drops the F-bomb. Faith. You need to have faith and truly believe that the magic formula will work - because it’s hard to not give up during the periods when the formula is underperforming the market. Usually, the animal instincts tend to take over and kick all rational argument overboard.
The author also tells you to give back to society and do good, now that you’re going to be all rich and famous. But you probably already have a laundry list of things to do, ready to go for when you become rich and famous. Let’s end this summary with a quote from the author - “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.”
Pro Tip - Don’t be an idiot.
Submitted January 30, 2017 at 09:30PM by AmeyDandawate http://ift.tt/2klhEAq
