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This year my father gave my Grandmother an investing book. It’s called The Little Book That Beats the Market, by Joel Greenblatt. I’d already read about Greenblatt before. His investment firm has averaged a jaw-dropping %40 in annual returns for over 20 years. Needless to say, I was more than a little curious what he had to say. I ended up reading the whole book yesterday, and figured I’d report on what I read.

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.