The little Book That Beats the Market – Joel Greenblatt

The Little Book That Beats the Market (Little Books. Big Profits)

  • Greenblatt, Joel
  • 1. If you really want to “beat the market,” most professionals fessionals and academics can’t help you, and 2. That leaves only one real alternative: You must do it yourself
  • eludes
  • Why do the prices of all these businesses move around so much each year
  • Mr. Market’s
  • investing with a margin of safety.
  • sane
  • all of our problems seem to boil down to this: It’s hard to predict the future.
  • rather own a business that earns a high return on capital than one that earns a low return on capital!
  • if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies nies that crazy Mr. Market has decided to literally give away.
  • Graham stated that it seems “ridiculously simple to say” that if one could buy a group of 20 or 30 companies that were cheap enough to meet the strict requirements of his formula, without doing any further analysis, the “results should be quite satisfactory.” In fact, Graham used this formula mula with much success for over 30 years.
  • A company that ranked 1st in return on capital ital but only 1,150th best in earnings yield would receive a combined ranking of 1,151 (1,150 + 1).*
  • IT AIN’T THE THINGS WE DON’T KNOW that get us in trouble,” said Artemus Ward, a nineteenth-century newspaper columnist. umnist. “It’s the things we know that ain’t so.”
  • ragtag
  • there are plenty of times when the magic formula doesn’t work at all!
  • Even professional money managers who believe their strategy will work over the long term have a hard time sticking with it. After a few years of poor performance relative to the market or to their competitors, the vast majority of clients and investors just leave!
  • As a professional manager, if you do poorly while everyone else is doing well, you run the risk of losing all your clients and possibly your job! Many managers feel the only way to avoid that risk is to invest pretty much the way everyone else does. Often this means owning the most popular companies, usually the ones whose prospects look most promising over the next few quarters or the next year or two.
  • The magic formula appears to work very well over the long term. 2. The magic formula often doesn’t work for several years in a row. 3. Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row. 4. For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.
  • This opportunity to invest profits at high rates of return is very valuable.
  • In other words, owning a business that has the opportunity to invest some or all of its profits at a very high rate of return can contribute to a very high rate of earnings growth!
  • So now we know two important things about businesses nesses that can earn a high return on capital. First, businesses nesses that can earn a high return on capital may also have the opportunity to invest their profits at very high rates of return. Since most people and businesses can invest their money at only average rates of return, this opportunity is something special. Second, as we just learned, the ability to earn a high return on capital may also contribute to a high rate of earnings growth.
  • In short, more competition could mean lower profits going forward for Jason’s Gum Shops. In fact, that’s how our system of capitalism works.
    This whole capitalism thing could result in profits continuing uing to spiral downward until the annual returns on capital tal from owning gum stores isn’t so great anymore. Some system!
  • In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special cial advantage keeps competitors from destroying the ability to earn above-average profits.
  • 1. Most people and businesses can’t find investments that will earn very high rates of return. A company that can earn a high return on capital is therefore very special. 2. Companies that earn a high return on capital may also have the opportunity to invest some or all of their profits at a high rate of return. This opportunity nity is very valuable. It can contribute to a high rate of earnings growth. 3. 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. 4. By eliminating companies that earn ordinary or poor returns on capital, the magic formula starts with a group of companies that have a high return on capital. It then tries to buy these above-average companies at below-average prices.
  • there are really two main things you should want to know about an investment strategy: 1. What is the risk of losing money following that strategy over the long term? 2. What is the risk that your chosen strategy will perform worse than alternative strategies over the long term?
  • Over the long term, crazy Mr. Market is actually a very rational fellow.
  • 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.
  • In fact, often the near-term prospects for the companies selected by the magic formula don’t look so good. In many cases, the outlook for the next year or two is downright right ugly. But that’s one reason the magic formula can find companies whose prices seem like bargains.
  • formula doesn’t pick individual stocks, either. It picks many stocks at one time. Looking at a whole portfolio of stocks, it turns out that using last year’s earnings is often a good indicator of what earnings will look like in the future.
  • The more confidence I have in each one of my stock picks, the fewer companies I need to own in my portfolio to feel comfortable.
  • we will want to sell a few days before our one-year holding period is up. For those stocks with a gain, we will want to sell a day or two after the one-year period is up. In that way, all of our gains will receive the advantages of the lower tax rate afforded to long-term capital gains (a maximum 15 percent tax rate under federal guidelines for stocks held more than one year), and all of our losses will receive short-term tax treatment ment (a deduction against other sources of income that otherwise could have been taxable at rates up to 35 percent). cent). Over time, this minor adjustment can add significantly cantly to our after-tax investment returns.
  •, aaii .com,,, and
  • For most individuals, companies with market capitalizations above $50 million or $100 million should be of sufficient size.
  •,, and may
  • Use Return on Assets (ROA) as a screening criterion. Set the minimum ROA at 25%.
    the lowest Price/Earning ing (P/E) ratios. Eliminate all utilities and financial stocks (i.e., mutual tual funds, banks and insurance companies) from the list.
    Eliminate all foreign companies from the list.
    If a stock has a very low P/E ratio, say 5 or less, that may indicate that the previous year or the data being used are unusual in some way.
  • EBIT/(Net Working Capital + Net Fixed Assets)
  • EBIT (or earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using operating earnings before interest and taxes, or EBIT, allowed us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.
  • Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business. Net working capital was used because a company has to fund its receivables ables and inventory (excess cash not needed to conduct the business was excluded from this calculation) but does not have to lay out money for its payables, as these are effectively tively an interest-free loan (short-term interest-bearing debt was excluded from current liabili-ties for this calculation). In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment. The depreciated net cost of these fixed assets was then added to the net working capital requirements already calculated to arrive at an estimate for tangible capital employed.
  • Intangible assets, specifically goodwill, were excluded from the tangible capital employed calculations.
  • ROE and ROA calculations used by many investment analysts are therefore often distorted by ignoring the difference between reported equity and assets and tangible equity and assets in addition to distortions due to differing fering tax rates and debt levels.
  • EBIT/Enterprise Value
    In other words, P/E and E/P are greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not.
    EV IS PRICE + Debt
    Let’s look at EBIT/EV for both companies. They are the same!
  • look-ahead bias).
  • survivorship bias).
  • Companies that are too small for professionals to buy and that are not large enough to generate sufficient commission revenue to justify tify analyst coverage are more likely to be ignored or misunderstood. understood. As a result, they are more likely to present opportunities to find bargain-priced stocks. This was the case in the magic formula study. The formula achieved the greatest performance with the smallest-capitalization stocks studied.
  • Robert Haugen and Nardin Baker.§