BOOK SUMMARY: THE BIG SECRET FOR THE SMALL INVESTOR: A NEW ROUTE TO LONG TERM INVESTMENT SUCCESS

BOOK SUMMARY

Book title: The big secret for the small investor: a new route to long term investment success

Author: Joel Greenblatt

Publisher: In United States, Crown Business, a division of Random House

Publishing date: 2011

Genre: Nonfiction, Stock Market

Number of pages: 94

Book price: Rs.955/-

The first thing that attracts you towards the book is its short length; the attraction just does not end there, on the contrary when you start to read through the pages of Joel Greenblatt’s book ‘The big secret for small investor’ it draws you in. And as you start to get engrossed into the subject you acknowledge the ease with which Greenblatt imparts his wealth of knowledge of ‘how to invest in stock market.’ The best bit about this book is that it is targeted at the share market novice. 

Starting at the start

At the onset of the book Greenblatt explains how his professors were wrong in instilling the fear in him ‘there are so many smart people out there, you can’t out smart them.’ According to the author he was constantly feed the idea that ‘only way he is going to find a bargain priced stock was by luck.’ Greenblatt mentions that tables have turned ‘he is now the professor and it is his duty to teach his students the correct knowledge of ‘spotting a good from a bad stock.’ Author further adds that the secret of beating the market is about learning a few simple concepts and sticking by them.

Parts of the book

The book consists of nine chapters: the first four not only builds the story of rational investing, but also shows the difficulty in deriving the value of any stock. Chapter five and six discusses the merits of being a small investor as compared to big professional investors. Then Greenblatt talks about indexing; equal weighted and fundamental weighted indexes, and presets the solution of an indexation based on the combination of relative size of the earnings yield of the stock and of the return on capitals in the companies.  Let’s take each chapter separately.

Concept of value

In this chapter Greenblatt elaborates on the concept of ‘finding the value of anything’ i.e. the secret to successful investing is to figure out the value of something and then pay a lot less. To explain his idea the author uses Benjamin Graham’s concept of investing with margin of safety, which was based on the idea that ‘if unexpected events lower the value of our purchase or our initial valuation is mistakenly high, buying with a large margin of safety will still protect us from by loses.’ And to explain his idea of value Greenblatt uses the example of Candy’s Candies and in the example he tries to answer the question ‘will Candy’s Candies earn $10,000 each year for the next thirty plus years?’ To standardize the equation Greenblatt; in the example, is the owner of the Candy’s Candies and will collect all the earnings; from the stock, at the end of each year and that a bank will pay him 6% on any deposit. So doing the maths Greenblatt figures comes out to be $9,434; first year, $8,900; second year, $8,396; third year, $7,921; fourth year, $7,473; fifth year, and so on and by the 31^st year it will be $1,643, giving the author a total of $166,667 - taken that all the assumption taken in the example are correct. Now imagine if Greenblatt is offered $80,000 to sell Candy’s Candies. Obviously Greenblatt won’t sell it; $166,667 is greater than $80,000. But here is the tricky part, think on the following - will the business grow? Or will Candy’s Candies even be around in thirty years? The fact is that projecting so far in the future is hard, and the assumption taken in the above are at best ‘guesses.’ So the main question comes out to be: ‘what would you pay more for – a guaranteed $10,000 a year for next thirty plus years or a guess of collecting $10,000 a year for next thirty plus years? It is obvious that you would go for guarantee.’ Normally an investor will discount the price they will pay for future earnings that are based only on estimates. The next question arises ‘how much less?’ After a few calculations it becomes clear that using different discount rates for different estimated earnings leads to different results. This exercise shows that: which number is correct? Which estimate of earning is right?  Greenblatt comes to the conclusion that getting an answer to any of the questions is difficult. Author thought this chapter teaches the reader a lesson – ‘value of a business is equal to the sum of all the earnings we except to collect form that business over its life time, because earnings from next quarter or next year represent only a portion of this value.’      

Other methods to find value      

In this chapter author explains other ways to determine the value of something. The first is relative value, i.e. what business is the company in? How much are companies in similar business selling for? Does that make it appear cheaper or more expensive than similar companies? These are the kind of questions to ask and things to compare. Then there is acquisition value, an example to explain it is – ‘if you have two companies, one with 50,000 customers and other with 200,000 customers, it may pay for the larger company to buy the smaller one. The larger company may earn a lot more from the additional 50,000 customers than the smaller one because it doesn’t have to pay all the expenses of operating an independent company. But the questions still stand – ‘how do you figure out how much more? Who gets the benefit of the cost savings, the buying company or the selling company? These questions need to be answered, which is tough to do. Next the author talks about liquidation value i.e. look to the assets of the company, not just its earnings. A company that loses money may be able to sell of its inventory, land, buildings or its brand name. According to Greenblatt out of the four - value, relative, acquisition and liquidation methods that professional analysts use to figure out the value of a company, none is easy to implement. In addition to the above methods the author mentions sum of the parts valuation i.e. often larger companies have a number of different divisions, with each division in different line of business. At the end of this chapter Greenblatt concludes that all the different methods are difficult to use, lead to inaccurate estimate of value and have many drawbacks.

Value against risk free earnings

Greenblatt starts this chapter with the assumption; described from first chapter, that estimating the earnings of thirty plus years of a company, and adding to it, finding its present worth is very difficult.  The solace which the author gives is that it is difficult for the smart, big professional investors also. Author provides an alternative – how much an investor can earn risk free; in the book author has taken the example of U.S. Treasury bond that will pay 6% a year for ten years. Greenblatt takes up another question – ‘if we invest $100,000 to buy the entire Candy’s Candies; from chapter 1, business and we earn $10,000 on our investment next year, is that better than taking that same $100,000 and investing it in U.S. government bond paying a guaranteed 6% per year for next ten years?’ The first point which the author explains is earnings yield, for example: earning $10,000 in the first year on investment of $100,000 is equal to 10% return on money – the earning yield is 10%. At first observation this 10% is greater than that of 6% which the government provides. But remember that 6% is guaranteed whereas 10% from Candy’s Candies is a ‘guess.’ Greenblatt says that ‘we as investor are no closer to finding out which is better – 10% or 6%.’ Author gives the option of comparing an investment in Candy’s Candies with some other investment opportunity say Bad Bob’s Barbeque Restaurant – which is also available at $100,000 and will earn $12,000 next year, i.e. 12% earning year for first year. Bad Bob’s Barbeque seems to be a good investment which is likely to grow more over the years, maybe more than Candy’s Candies. Author reaches the status that while both of the investment are more attractive than the government bond, it is also clear that Bad Bob’s Barbeque is more attractive investment than Candy’s Candies; 12% instead of 10%. Of course, if author has high confidence that both investments offer a better deal than the risk free government bonds – buy both. According to Greenblatt this is ‘how author goes about when evaluating and comparing business to invest in a portfolio.’ At this point the author asks his students; remember chapter 1, ‘what happens if we are trying to value a company and we are having a hard time estimating future earnings and growth rate?’ While thinking on the above, also add questions – ‘may be the industry is very competitive and we are not sure about the estimated future earnings? Or we are questioning whether some of the new products of the company will be successful or not? Or we are not sure whether the new technologies will affect a company’s service or product?’ Greenblatt answers when an investor finds difficulty then skip the company and look for another. Author knows that the process of estimating the future earnings and growth of a company is very difficult, and emphasis that this whole process was to show the reader/small investor that even the best, smartest, and biggest of the professional investors find the process extremely tough.     

Flying under the radar

Greenblatt starts the chapter by emphasizing the importance of ‘playing a different game’ by the small investor to beat all the smart guys that are backed by experience, research and millions and millions of dollars. According to the author the best way to play the market is ‘fly a little below the radar’ i.e. buying shares in small companies where the big boys can’t play? Greenblatt adds that ‘sticking to analyzing and investing in a few companies where you have special insight or some deeper knowledge make good sense.’ Author points out that stock market are laden with special situations investing: places where it is not important to predict the future, because bargains are found here. Greenblatt mentions some of these special situations as – spinoff, public offering, bankruptcy, restructurings, mergers, liquidations, asset sales, distribution, right offerings, recapitalizations, options, smaller foreign securities, complex securities. However, according to Greenblatt finding these special situations; by the investor, also proves to be difficult because of the following reasons. First, each investment requires a reasonable amount of time and efforts to find and evaluate .Second, to find these special situations some basic valuation skills are necessary. Third, many of these situations are relatively small in size; so missed by both small and large investors.  

Talk about mutual funds

The author starts this chapter with a look back of all that has been thus far covered in the book – ‘figure out the value of something and pay a lot less. It is difficult to figure out what a company is going to earn next quarter, but we have to make guesses about earnings for next ten , twenty and thirty years. Even very small changes in our estimates for future earnings, growth rate and discount rates make a huge difference in estimate of value. Other methods of finding value can lead to inaccurate estimate of value. Even comparing our investment to risk free rate must rely on accuracy of our estimate and our ability to asses our level of confidence in those estimates. And coming up with those comparisons for different companies is hard work.’ At this stage of the book Greenblatt talks about Mutual Funds: active and passively managed. Author focuses on active mutual funds and explains how managers of mutual funds earn money by getting investors to invest as much money as possible with these mutual funds, which excludes them from investing in small caps. The main reason why mutual funds choose to own dozens or hundreds of stocks is ‘they don’t like to lose.’ Greenblatt stresses on the point that a portfolio of only ten or twenty stocks can vary widely from the return of a market index that contain a portfolio of five hundred or thousands stocks. And adds that ten or twenty favorite picks has the chance to do well above average, but unfortunately, according to the author it may also do below average. The investor has no chance to figure out why a particular manager underperforms – the reason is mostly they; investors, don’t stick around. Managers know that – ‘managing a concentrated portfolio may be a great way to beat the market averages, but over shorter time however it is also a great way to risk your business and your career’ so managers do what is important to have a continuous flow of business. Finally, Greenblatt states that on average and over time, actively managed funds lose to passive index funds by approximately the amount of their higher management fees. At the end of the chapter, author explains that investors also lose money in mutual funds because of poor timing decisions.   

Regarding indexes

In this chapter author talks about index funds: funds designed to match the return of popular indexes, for a small fee. The advantage of this is that it can be implemented very cost efficiently and efficiently. And its negative point is that the index is market cap weighted; the larger the market capitalization of a company, the larger the part of that company in the index, the more overvalued a company is the more over weighted it becomes, so the investor end up systematically owning too much of that companies that are overvalued and systematically too little of the companies that are undervalued. Then author proceeds to give a better alternative to market cap weighted indexes – equal weighted indexes: in which each company has the same weighting. According to the author this adds on average 1-2% of returns per year over market cap weighted indexes. The disadvantage of this process is that these indexes can’t handle too much money due to the smaller constituents in the indexes. Next Greenblatt talks about fundamentally weighted indexes; where the weighting of a company in an index is determined on the basis of one or more fundamentals like earnings, sale, dividend etc. In the book Greenblatt explains all the three: market cap weighted, equal weighted and fundamentally weighted indexes by taking three companies A, B and C. 

Market Capitalization                                              Last year’s earnings      

       

Company A               $6 billion                                                                    $100 million

Company B               $3 billion                                                                    $300 million

Company C               $1 billion                                                                    $200 million

Total market cap =    $10 billion     Total earnings of all companies =             $600 million             

of all companies

Ø  Market cap weighted index

Company A = $6 billion/$10 billion = 60% weight in index

Company B = $3 billion/$10 billion = 30% weight in index

Company C = $1 billion/$10 billion = 10% weight in index

Ø  Equally weighted index

Company A = 33% weight in index

Company B = 33% weight in index

Company C = 33% weight in index

Ø  Fundamentally weighted index

Company A = $100 million/$600 million = 16.7% weight in index

Company B = $300 million/$600 million = 50% weight in index

Company C = $200 million/$600 million = 33% weight in index

Greenblatt’s conclusion for this chapter is that fundamentally based indexes are probably a better option to replace market cap weighted indexes than are equally weighted indexes.

The book’s secret

This chapter highlights value weighted index; the big secret of the book, in which the cheaper a company appears, the larger its weight in the index. According to Greenblatt ‘it is best to look at how cheaply we can buy a company relative to its last year of earnings.’ Author adds Benjamin Graham’s focus on ‘buying companies at prices well below fair value’ to Warren Buffett’s concept ‘while buying a business at a bargain price is great, buying a good business at a bargain price is even better’ in coming up with the value weighted index. According to the author with the value weighted index, investors not only remove the systematic error that is present in a market cap weighted index, but can also add to the performance by buying more stocks when they are available at bargain prices.     

Why strategy fails?

In the last chapter of the book Greenblatt explains why that ‘the big secret’ fails in making the investor money. According to the author the first part of the ‘big secret’ is to have the right strategy; which is to invest in companies that are both cheap and good. And the second part of the ‘big secret’ is that the investors need to stick to that strategy over long period of time’ preferably three to four years. According to Greenblatt - sticking to the strategy is very difficult for the investor because most investors are practically hardwired from birth to be lousy investors: impatient, loss averse, have herd mentality, focuses on recent events and are overconfident.    

Final thoughts

It is easy to read book, discussing, how to invest in the stock market – as clearly mentioned by Greenblatt in the last chapter, where he says, ‘this book has been a discussion of how to invest in the stock market’ is a great read; regardless of your experience in investing.

          

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