The Little Book that Beats the Market

I usually avoid books that promise a “magic formula” to investing; but, author Joel Greenblatt, is a successful money-manager, and the library had an audio version of his book “The Little Book that Beats the Market“, and the book had good reviews.

Using a simple example of a kid selling gum in school, Greenblatt asks how much one would pay to become a partner, getting half of the gum-selling business. The first five chapters are a great summary for someone who has never thought about stock-investing.

Next, Greenblatt explains his “magic formula”. Among the various measures that make a stock attractive, he isolates two factors and explains why those two are fundamental. He argues that many other factors depend on these two, or are simply not as important. He tells individual laymen investors to ignore most other factors, rate companies using only the two publicly available measures, and promises that they will beat the market in the process.

Even though the Greenblatt is substantially correct in the metrics he identifies, and has back-tested his formula over data from the past 20 years or so, that is dangerous advice to someone who knows nothing about stocks. Everyone who invests should also understand the basic objections to stock-picking, made by the “Efficient Market” school. (Not that I agree with the latter, but one should understand the point that they make, and why average-performing “Index Funds” are suitable for many investors. John Bogle’s little book should be a good companion read.)

Also, from any ‘mechanical’ screen, the investor would need to exclude certain companies that are in there for the wrong reason. (Greenblatt mentions, in passing, that one should remove Financials and Utilities. Given the times, perhaps he ought to have added a caution about natural-resource companies as well.) [Check this Barron’s article for a critique.]

Greenblatt has a web-site where one can get a list of (say) top 25 companies, using his criteria. When I tried the site though, the “Return on Assets (ROA)” numbers were way off. For instance, DLX showed up with an ROA of over 100%, while both S&P and Yahoo-Finance calculate it to be around 10% (and the latter is definitely closer to reality). So, if a novice tries to follow the “magic formula”, without reading anything else, he actually will not follow the advice after all, because he’s probably going to be using bad data!

I think the real audience of the book is the large contingent of amateur individual investors who lean toward “value-investing”, and are at least knowledgeable enough to spot basic data problems. For such an audience, the early chapters are slow, explaining basic concepts from scratch. Nevertheless, the basic theme — Greenblatt’s isolation of two factors as being fundamental — is definitely food for thought.

So, if you’re a novice, read the book but you’ll need to read some others as well, before acting. If you do invest in individual stocks, it’s a book worth reading and thinking about.

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5 Responses to The Little Book that Beats the Market

  1. Tony says:

    To your comment concerning inaccurate ROA, you might want to go back and read the book. Greenblatt does not use return on assets; he used pre-tax return on invested capital, and there are nuances to the calulations he uses to arrive at that figure. All that might be lost in a casual listen to the audiobook, especially since much of the details are buried in the appendix of the book.

  2. Tom says:

    I suspect you may not have paid enough attention to the details of the methodology presented in this book. Some of the calculations are somewhat different to the norms used in investing, and are particularly relevant to the ranking scheme.

    It only takes an afternoon, I would be interested to see an updated blog entry once you have re-read the book.

  3. MoneyIsGood says:

    Thanks for the comments. The audio-book mentioned the appendix, but it was not read out. I think it did mention that ROA from other investment sites was the closest commensurate figure.

    Your comments have intrigued me enough that I will pick up the book, and the check the appendix.

    It does confirm my suspicion that the book is really aimed at value-oriented individual investors with a modicum of layman’s experience with investing, rather than at novices.

    Thanks again, both.

  4. black_mamba says:

    Is this gonna Kill You? No i Dont Think so !

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