The Little Book that Beats the Market
January 27th, 2006 by Mark
This year my father gave my Grandmother an investing book. It’s called The Little Book That Beats the Market
The Little Book that Beats the Market is aimed at beginning investors. It starts with very clear explanations about the nature of investing in general and investing in stocks in particular. I can’t say I’ve seen too many books that would be as clear to the layman. Then the book goes on to tout its “magic formula” for beating the market. It’s a mechanical investing approach that involves buying stocks based on ROC and P/E. Being an academic, he used “Earnings Yield”, which means E/P instead of the commonly used P/E. The method does indeed have an impressive track record that is based neither on data-mining, nor on “survivorship”. The method has a great rationale, too: buy companies that generate lots of money when you can buy them at deep discounts. All in all this is a great book for a novice investor and I’m really glad my Grandmother has it.
Still, I’m somewhat skeptical of mechanical investing. Despite the book’s arguments to the contrary, I’m pretty sure that if the “magic formula” really is that good, then more and more institutions will start to use it. After that, the returns would have to dry up pretty quickly since it’s impossible for everyone to beat the market. Basically, what I’m saying is that right now there’s a pricing inefficiency. As always in the case of pricing inefficiencies, the first to find them can make a lot of money, but it disappears once enough people are aware of it. The Little Book that Beats the Market was just published this year (2006). If you don’t mind betting your savings on an algorithm and you want to make money from the “magic formula”, now is the time. It may not be that useful anymore in a couple of years.
Note: Joel Greenblatt used EBIT/(Net Working Capital + Net Fixed Assets) to calculate ROC, and EBIT/Enterprise Value to calculate Earnings Yield. He ranks all the stocks above a certain market cap based on ROC, and then he ranks them all by Earnings Yield. After that he adds the two rankings together to get a grand ranking. For example, a stock ranked #4 in terms of ROC and #732 in terms of EY would have a total rank of 726. Another stock ranked #50 on both lists would have a total rank of 100, and thus be the better buy. His system is to rank all the companies above a given market cap, and then buy the top 30, hold them for one year, sell them, and then buy the new top 30 ranked companies of that year.
:
February 25th, 2006 at 5:51 pm
Just an observation to ponder: you say “since it’s impossible for everyone to beat the market” which indeed is very true. . if everyone did the same thing. However this logic could be applied to index funds as well since if every investor save for 2 were to invest in an index fund, those 2 investors would control the price of every ones’ investment, hence an index fund wouldn’t work if “everyone” were to invest entirely in them. Also planning a career wouldn’t be of much use either if “everyone” chose the same career since the market demand would be nil for any new comers to that occupation. This thought could basically be applied to any investing method: if everyone were to do the exact same thing , you would not beat the average. But what is the chance of getting everyone to do the same thing?? This thinking is the fallacy of the continuum. Now that I verbosely stated that, I agree with you that investing in a “blind” algorithm is not the way to go. My intention with this book is to introduce folks to the concept of value investing and also as a confidence builder that teachers folks to use and transfer skills they already have such as value shopping for antiques. . . you want to buy an item of quality with out paying too much to get that quality. . . same with stocks.
February 25th, 2006 at 8:17 pm
Hey, Dad! It’s great to see you posting here! I think the book was a great gift for Grandma. It breaks things down and explains them pretty clearly. I’m not sure if she’s finished reading it all yet, but she’s at least gaining a little bit of confidence. What you said about confidence big issue. Investing is pretty scary to a lot of people.
As for what you said about beating the market, I totally agree that index funds is no way to do it. I just like them because they don’t lose to the market by 2-3% or whatever their fees are per year. Right now I’m investing the majority of what I save in stocks (through a discount brokerage), and I do run my purchases through the formula in that book. I’m still looking at other things, though. I probably wouldn’t have invested in Shanda (盛大) if I thought their games were boring, for example.
Hmm… it sounds like the only way to win is to recognize when and how people tend to be irrational and somehow manage to resist the same tendencies in oneself.
February 26th, 2006 at 10:23 am
Good to hear from you too!!! Yes, your grandmother claims to be reading the book. As I told her, I am glad you persuaded her to do what she is doing!!! I feel much better with her using your advice vs what she was doing. Funny thing, you are having her do some of the same things I was trying to persuade her to do. I am glad you were sucessfull!! But any way thank you. She is also claiming to post to your site as well…although she didn’t say when.
How have the companies you have selected scored using “the magic formula” as compared to the relative competition? Most of my $ was in Cat stock these past 2 years which returned for me better than 30%. I am no longer invested in it now, however as I sold it last month. I have not decided what to invest in next. I have not been active in keeping up with FASB changes or any market/company research. I plan to do some reading first, but I will probably run some of my ideas by our site to get opinions or criticisms. I have pretty much ruled out any stocks that deal with transportation (trucking, shipping, airlines, rail and etc and I also don’t like any insurance holdings either although I will admit others have made good money in both. I just don’t sleep well on those kind of investments since one stroke of bad luck seems to turn an entire company or industry upside down and the transportaion companies generally operate on a very close/tight margin to begin with….and then an accident/strike/supply problem seems to occur.
You stated it much more concisely than I could have. I don’t think you can save/invest and live in a thrifty way and still be mainstream. Society seems to value saving/investing as good, but then most temptations offered (along with the marketing)seem to encourage actions to the contrary.
Do you think it is within reason to learn the chinese characters and their use well enough to learn how to read via a course of books or via the internet?
Do you have to register this blog with the government or does that exclude Taiwan?
February 26th, 2006 at 5:02 pm
Well, I think it was the combination of you, me, and Claude that was finally enough to convince her. She hasn’t posted here, by the way. Maybe she got hung up with the required email address. I’m not sure.
For the most part, they’ve scored very well compared to their direct competitors. That said, I don’t check them as often or as well as I’d like to.
For my US investments, I can get all the information I need, but it’s very time consuming. I really wish I had a better tool for getting this information. Yahoo Finance, and Big Charts are useful, but I usually have to go to the company’s own website to get a full 10Q in order to calculate a company’s earning yield or ROC using Greenblat’s metrics. Even then, it takes some math to get the inputs I need. EBIT is easy enough to find, but the terms Net Working Capital, Net Fixed Assets and Enterprise Value are usually nowhere to be found.
February 26th, 2006 at 5:25 pm
If you mean without a teacher, then I’d say yes but it would be a lot harder.
Taiwan is a rogue province that originally had plans of conquering the mainland, and is now debating independence. Mainland laws mean nothing here. That said, my blog isn’t even blocked in China. Strangely, it was when I was on Hostgator’s server#48. Once I moved to Hostgator’s server#50 I was unblocked. Some bloggers who have much larger readerships than I do, occasionally write about Chinese censorship, and who write Chinese in the simplified characters used in mainland aren’t blocked. Other times, completely harmless sites about baby names get blocked.
January 2nd, 2007 at 5:21 am
I have red hundreds of books on value investing, Warren Buffett etc, and publish investment tutorials on value investing myself. I highly recommend Greenblatt’s ‘the little book that beats the market’. Literature on Buffett / value investing / competitive advantages probably would I also recommend, when interested in a deeper understanding of value investing.
Success in investing,
Hendrik Oude Nijhuis
http://www.magicformulastocks.com
February 25th, 2007 at 8:44 am
Would you still happen to have this book? His investing strategy sounds similar to Warren Buffet (I just grabbed one of his books), except Mr. Buffet buys into businesses that he really wants to own and would never sell. The math for finding these businesses sounds exactly the same though.
I would like to blend the magic formula along with my own personal knowledge and research.