The Little Book That Still Beats The Market
Who is Joel Greenblatt?
Who is Joel Greenblatt? Joel Greenblatt (born December 13, 1957) is an American academic, hedge fund manager, investor, and writer. He is a value investor, and adjunct professor at the Columbia University Graduate School of Business. He is the former chairman of the board of Alliant Techsystems and founder of the New York Securities Auction Corporation. He is also a director at Pzena Investment Management, a high-end value firm.
In my opinion, after having read many books on investing, this must be the first book one should read to build a foundation for investing. Joel wrote this book in a very simple language so that his sixth grader kid could understand. Anyone can digest the content without any prior financial/business knowledge.
Joel teaches a basic, but fundamental, lesson to his son Ben (sixth grader) about investing in a business through a story. The story is about Ben’s friend Jason who would buy 15 sticks of gum for 5 cents each and would sell it to fellow students for 25 cents each. Ben figured that Jason makes $3 every day, 5 days a week, and Jason will make $3,000 by the end of high school ($3 x 5 days a week = 15, $15 x 36 weeks of school = $500 a year, $500 x 6 years until he graduates = $3,000).
Joel asks Ben: ‘If Jason decides to sell half of his business, how much would you pay to get $1,500 over six years?’ Ben thought $450 would be a reasonable price but asks why anyone would sell for $450 if it's worth way more than that. That is a most fundamental attribute of a value investor – find and buy a business at a bargain price.
Resisting the temptation to spend money on things we don't need and saving requires a great deal of discipline. Let's assume you're able to save; now the challenge is to grow the money over time. Money that doesn't grow is worth less than it was worth the day it was saved. Banks, bonds, government bonds can grow your money with guaranteed interest rate but Joel prefers investing in stock in order to grow it rapidly.
After exploring many logical ways of investing, investing in business is only a good option. Let’s assume Jason has grown up quite a bit and has opened a bunch of gum stores. He now wants $6 million for half ownership of his business but luckily Jason has decided to divide ownership of his entire business into 1,000,000 (1 million) equal pieces, or shares for $12 apiece. Determining $12/share is a good price in relation to its come is a key in value investing. Always remember, owning a share means owning a portion of that business and thus entitled to a portion of business future earnings.
Let's assume Jason’s stores sold $10 million worth of gums (revenue) and after deducting all the expenses and taxes, net profit was $120,000. If you divide $120,000 (net profit or earning) by 100,000 (total number of shares), that will be $1.2 profit per share (also known as Earning Per Share (EPS). $1.2 will be 10% of each share price which is way better than what bank, government or bond offers.
Many times share price of companies goes up and down wildly over a short period of time, but that doesn't mean the underlying value of business also changed. All we need to figure out how much a business is worth, and buy shares at a discounted price. Let's assume Jason’s business is worth $12 a share and its price goes up and down wildly from $6 low to $12 high. Buying at $6 will provide a good margin of safety even if our estimation was high; would you not want to earn $1.2 on $6 (20% earning yield) instead of $12 (10% yearning yield). But the question is: how do you know that Jason’s business will continue to earn $1.2 a share in years to come?
A problem with an estimate of future earning of any business is that it’s just an opinion; it’s hard to predict the future. Instead of focusing on what we don't know, focusing on two important available pieces of information will be wiser. First, it’s always better to buy a share with high earning yield relative to its price, i.e. 30% is better than 10% or 20% that provides a good margin of safety.
Secondly, buy a business that can get a high rate of return by investing its own money, referred as return on capital. Let's assume Jason opens a new store by investing $400,000 and earns $200,000, that's a 50% return on capital. But Jason's friend Jimbo also has a chain of stores and it also cost him $400,000 a store but each of those stores only earned 10,000, that's only 2.5%. Whose business should you be buying, Jason’s or Jimbo’s? High yield relative to its price and high return on capital is key.
Benjamin Graham, one of the most respected and influential pioneers in the investment field, first introduced a magic formula called ‘net-current-asset’ (stocks selling below their net liquidation value). It was easy to find a group of 20-30 companies using his formula at that time when companies were trading cheaper. Unfortunately, there are hardly any companies that would qualify under Ben’s formula. Joel’s magic formula is not time-bound; it ranks companies that have the best combination of high earning yield relative to its price and high return on capital. Using Joel’s formula, investment of $11,000 in 1988 would have turned well into 1 million in 2004.
Joel proves through his research that regardless of the size of the company, magic formula always works. One might think that the formula got lucky with a few good stock picks, but the magic formula was tested over the period of 17 years with a portfolio of 30 best picks. Joel argues that formula will continue to work in future as well as it looks for companies that have the best combination of a high yield return on capital and a high earnings yield.
Magic formula may not work for short-term; in fact it didn’t work 4 out of every 12 months and once in every 4 years. But it appears to work over long term and if you wish to invest using magic formula, even a shorter time horizon will be years, not days or months. But it will be most beneficial to maintain a long-term investment horizon (10 years or more).
Companies that earn a high rate of return are special because they either distribute the profit to shareholders (shareholders can reinvest to make more money) or invest in a new business that will again give a high rate of return. Investing profits at a high rate of return will significantly contribute to earnings growth. Even though there is no guarantee that the company will continue to earn a high profit, last year's high return still a good indicator.
In addition, there is something special about those companies’ business (products and/or services and market) and their ability to run a business at a low cost. Therefore, they have a unique competitive advantage.
When thinking about the risk, there two important questions one must consider about any investment strategy:
What is the risk of losing money following that strategy over the long term?
What is the risk that your chosen strategy will perform worse than alternative strategies over the long term?
Because magic formula strategy never lost money in any three-year period and consistently beat the market averages, it is a highly risk aversive investment strategy.
There is one thing everyone should know about Mr. Market (stock exchange market) that, in the short term, it may determine stock prices based on emotions but over the long term, it is the value of the company that matters most to Mr. Market.
If you think magic formula is boring and you want to pick individual stocks yourself, you can still use magic formula to find companies with high earning yields and high return on capital. You can then start plugging in future earnings estimates using a risk-free rate (3% would be ideal). Since you also need to be confident with your earning estimate, more conservative estimates the better. Limit your stock investment to a number of good companies available at a bargain price. Five to eight companies in different sectors will suffice. If you're not an expert in valuing businesses and making predictions, stick with magic formula and invest in top ranked 20 to 30 companies.
If you have some money that you would like to invest for at least 3-5 years and earn above average return, going to stock broker, or investing in mutual fund (managed by professional money managers who buy a diverse group of stocks and bonds), index fund (a mutual fund that just tries to equal the market's average return) or hedge fund (exclusive private investment funds usually reserved for very wealthy people) will not help. Instead, following step by step instructions below will help to pick stocks that will earn above average return.
The sooner you start saving and investing the better it is. Your $28,000 invested today will grow to $720,000 after 20 years and more than $4.3 million after 30 years if it earns 20% each year. There is no guarantee that magic formula will continue to earn over 30% in next 30 years as well. But, if you are able to stick with magic formula strategy through good and bad times, you will handily beat the market average over time.
Since magic formula works on average, consider holding at least 20 to 30 companies.
Step 1: Go to magicformulainvesting.com
Step 2: Choose company size preferably over $100 million
Step 3: Follow the instructions to obtain a list of top-ranked companies
Step 4: Buy five to seven companies to start with. Invest only 20 to 33 percent of the money you intend to invest.
Step 5: Repeat step 4 every two to three months until you have invested all the money you have chosen to allocate your magic formula portfolio. After 9- 10 months you’ll have 20 to 30 stocks.
Step 6: Sell each stock after holding it for one year. Use proceeds from any sale and additional investment money to replace the sold companies with an equal number of new magic formula selections (step 4).
Step 7: Continue this process for many years (minimum 3-5 years regardless of results).
Step 8: Feel free to write and thank Joel.
If you want to use screening option other than magicformulainvesting.com, do the following:
Use return on assets (ROA) as a criterion, minimum 25% (this will take place of return on capital from the magic formula study)
From the results, screen the stocks with lowest price/earning (P/E) ratio.
Eliminate all utilities and financial stocks, and all foreign companies.
Eliminate all stocks with a P/E ratio of 5 or less.
After obtaining your list, follow steps 4 and 8 from the Option 1 above.
Afterword to the Edition 2010
Ben graham, pioneer of value investing, taught us important eternal principles of value investing. Two of them are: Margin of Safety and Mr. Market (markets are emotional). Since magic formula seeks to find companies at a bargain price, it seeks that margin of safety. And because it's a formula it doesn't take emotions into accounts.
Magic formula means 100% in stocks and tough times are inevitable whether in short term or once every four years. Therefore, it’s important to determine how much you want to invest in stock market and it’s pretty much a personal decision. One way to decide is asking how much you can afford to lose before you panic out.
The Magic Formula
Return on Capital:
EBIT / (Net Working Capital + Net Fixed Assets)
EBIT / Enterprise Value
EBIT - Earnings Before Interest & Taxes
Net Working Capital: Current Assets - Current Liabilities
Market Capitalization + Debt + Minority Interest + Preferred Shares - Total Cash and Cash Equivalents.
Hope you enjoyed reading! You can connect with me on Twitter @JalalSali
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