BOOK SUMMARY: THE LITTLE BOOK THAT BEATS THE MARKET
Book
title: The little book that beats the market
Author:
Joel Greenblatt
Publisher:
John Wiley and Sons, Inc
Published
date: 2006
Genre: Nonfiction,
Stock market
Number
of pages: 155
Book
price: Rs.1272/-
Why
write this book?
At the very beginning of Joel Greenblatt’s book ‘The
little book that beats the market’ author gives his motivation in writing this
book. His reason – the book was originally inspired by my desire to give each
of my five children a gift. I figured if I could teach them how to make money
for themselves, then I would be giving them a great gift.’
The
book contains
Greenblatt; a successful investing professional and also
an Ivy League business school professor, in the book take up and explain some
of the questions: how to view the stock market? Why success eludes almost all
individual and preferred investors? How to find good companies at bargain
price? Etc. These questions help the reader in understanding the ‘ins and outs’
of stock market. Author divides the book into thirteen chapters, which are a
combination of profound insights and introduces most stock market concepts.
Chapter
1
Greenblatt starts the chapter narrating the story of a
six grader Jason; his son’s friend from school, who runs a business of selling
gum. Jason buys four or five packs a day, for 25 cents for a pack that has five
sticks of gum to a package, and sells each stick of gum for 25 cents. In the
process Jason rakes up $1.25 for each pack. Observing this author one day asks
his son –‘how much do you think Jason can make by the end of high school?’ After
a few calculations the author’s son comes with a figure of over $4000. The
investing teacher in the author springs up and he asks ‘if Jason offered to
sell you half his business, how much would you pay?’ This simple question
forces the son to come up with different figures; by taking higher or lower
estimates. As the discussion proceeds between the father and son duo, and more
calculations are done the idea of ‘buying a business for a lot less that what
it is worth’ springs up. Greenblatt uses the rest of the book for making the
reader/small investor understand where to look and how to buy these bargains.
Chapter
2
In the chapter author makes the reader understand the
concept and importance of investing. First Greenblatt talks that – ‘by being
careful about how much you spend, you have some money put aside say $1000.’
According to the author the challenge is to put that money where it can grow to
make more money. Thereon the author discusses the merits and demerits of
investing that money from: burying under a mattress; no change in the original,
investing in banks; earn a small interest on the original, and investing in
business as bonds; it pays, say8%, each year and pays back original $1000 after
10 years – surely investing in bonds is better than investing in banks, but
what ‘if something goes wrong in business of the company you buy bond from and
you are not able to get neither your interest nor your original.’ Then author
discusses the U.S. government bond; risk free investment, and explains that ‘if
anyone asks you to loan, they better expect to pay more than, say 6% per year,
U.S. government bonds. ’
Chapter 3
Greenblatt in the chapter thinks of investing in Jason’s
gum business; from chapter 1. Author supposes that – ‘Jason’s gum business has
grown tremendously and he now wants $6 million for half ownership of his
business. And for that he has decided to divide ownership of his business into
a million equal pieces or shares. Jason plans to keep 500,000 shares for
himself and sell his other 500,000 share for $12 apiece or $6 million in
total.’ Now the author comes to the important question –‘whether buying a share
at $12 apiece good business for the investor?’ Greenblatt answers that investor
needs to look at the information provided by Jason’s company ‘we know that
Jason wants $12 for each share and that there are 1 million shares in total so
this means that Jason thinks his business is worth $12 million.’ But the
investor needs to find that for themselves. Therefore author continues to look
at the figures provided by Jason ‘last year Jason sold a total of $10 million
worth of gum form the 10 stores, of course the $10 million isn’t Jason’s
profit, and his business has to pay expenses: salaries, taxes and other
payments. So calculating all Jason’s gum business earned $1.2 million; after
deducting expenses, last year.’ Now Greenblatt ask ‘knowing all this should the
investor buy Jason’s gum business share at $12 apiece?’ To find that out author
explains ‘Jason has divided his business into I million equal shares, i.e. if
the whole business earned $1,200,000, each share earned one millionth of that
amount, so $1,200,000 divided by 1,000,000 is $1.20, each $12 share was
entitled to $1.20 in earnings.’ According to Greenblatt that is a good deal
because $1.20 divided by $12 gives 10% returns, which is better than U.S
government bond. Now the author brings another question ‘okay the business
earned $1.20 per share last year, but whether the business will be that much
successful: gain or loses – next year also?’ Greenblatt understands that it is
difficult question to answer not only for the small investor but also the big
professional money managers.
Chapter
4
Greenblatt in the chapter explains the working of a share
market; and for that he goes into his class room making students understand the
wide variety of fluctuations of share price form day to day or week by week.
Author uses an example: say that the price of one share of General Electric was
$35 yesterday and the highest price that General Electric share have sold for
over the last year was $53 per share. Pointing these variations Greenblatt ask
‘how can this be? And adds that - ‘it cannot be possible that a company is worth
$30 billion becomes $60 billion one day or few months later.’ The easy answer
to this according to the author is ’people go nuts.’ For explaining in detail
the reason for this crazy fluctuation in market/share price, Greenblatt use
Benjamin Graham crazy guy named Mr. Market – who is subject to wild mood
swings. Author explains ‘each day Mr. Market offers to buy your share of
business or sell you his share of the business at a particular price. Mr.
Market always leaves the decision completely to you and everyday you have three
choices: you can sell your share to Mr. Market at his stated price, you can buy
Mr. Market’s share at that same price or you can do nothing. Sometime Mr.
Market is in such a good mood that he quotes a price that is much higher that the
true worth of the business, on these days, it would probably make sense for you
to sell Mr. Market your share of the business. On other days, he is in such a
poor mood that he names a very low price for the business, on these days, you
might want to take advantage of Mr. Market’s crazy offer to sell you shares at
such a low price and to buy Mr. Market’s share of the business. If the price
named by Mr. Market is neither high nor extraordinary low relative to the value
of the business, you might very logically choose to do nothing. That in a
nutshell how stock market works.’ Greenblatt further adds that Benjamin Graham
practice of investing with a ‘margin of safety,’ i.e. the difference between
your estimated value per share of say $70 and the purchase price of your share
of perhaps $37 would represent a margin of safety for your investment. At this
point Greenblatt says ‘understanding all this is okay, but adds that the problem
of finding what a business is worth still exists.’
Chapter 5
In the chapter Greenblatt once gain goes back to the
original problem that – ‘it is hard to predict the future and if we can’t
predict the future earnings of a business, then it is hard to place a value on
that business. And if we can’t value a business, then even if Mr. Market goes
crazy sometimes and offers us unbelievable bargain prices, we won’t recognize
them.’ So author says ‘rather than focusing on things that we don’t know, let’s
go after things that we do know. ’ The first point which Greenblatt wants the
reader/small investor to focus on is earnings yield, and in explaining that
author asks the following question ‘if you could buy a share of Jason’s Gum
business; from Chapter 1, for $12, which of these earnings results would you
prefer? Would you prefer that Jason’s business had earned $1.20 per share last
year, $2.40 per share or$3.60 per share? In other words, would you prefer that
the earnings yield calculated using last year’s earnings was 10%, 20% or 30%?
Obviously, you would rather go for higher earnings yield than the lower ones.
The second point Greenblatt wants the reader/investor to look for is return on
capital, for example – what if we found out that it cost Jason $400,000 to
build each of his gum stores, and that each of those stores earned him $200,000
last year. That would mean, at least based on last year’s result that a typical
store in Jason’s business earns $200,000 each year from an initial investment
of only $400,000, i.e. 50% yearly returns: which is good.’
Chapter 6
The chapter contains Greenblatt’s magic formula, author
ask – ‘what would happen if we decided only to buy shares in good business; one
with high returns on capital, but only
when they were available at bargain prices; priced to give in high earnings
yield? Greenblatt’s short answer is ‘we will make a lot of money.’ Thereon
author explains how the magic formula chooses good companies at bargain prices
– ‘the formula starts with a list of the largest 3,500 companies available for
trading on one of the major U.S. stock exchanges. It then assigns a rank to
those companies, from 1 to 3,500 based on their return on capital, i.e. company
whose business had the highest return on capital would be assigned a rank of 1,
and the company with the lowest return on capital would receive a rank of
3,500. Then the formula proceeds, but this time, the ranking is done using
earnings yield, i.e. the company with highest earnings yield is assigned a rank
of 1 and the lowest a rank of 3,500. Finally, the formula combines the
rankings: the formula looks for companies that have the best combination of
these two factors. For example, a company that ranked 232nd best in
returns on capital and 153rd high in earnings yield could receive a
combined ranking of 385; 232+153. Greenblatt ends this chapter with claim that
a portfolio of 30 or so of the highest ranked stocks will be a good investment.
Chapter 7
Greenblatt in the chapter takes different approaches and
tries to prove that the magic formula works regardless of the situations. The
first situation which the author talks about is that ‘the magic formula may be
picking companies that are so small that few people can really buy them, i.e.
often small companies have very few shares available for purchasing and even a
small amount of demand for these share can push share prices higher. If that is
the case, the formula may look great on paper, but in the real world, great
results can’t be replicated. That’s why it is important that the companies chosen
by the magic formula be pretty large. To test this author chooses the largest
2,500 companies; the smallest companies in this group have market value of at
least $200 million. After calculating the magic formula doubled the market’s
average annual return. Then Greenblatt narrowed the group of companies to just
1000 stock with companies with market value over $1 billion. There again magic
formula doubled the market’s average annual return. Author used the magic
formula in few more situations and as before the magic formula produced better
than market average annual returns.’
Chapter 8
Author in the chapter ask the question – ‘how can our
strategy keep working after everyone knows about it?’ The first part of the
answer according to Greenblatt is that ‘it turns out that there are plenty of
times when the magic formula doesn’t work at all, sometime the magic formula doesn’t
work for full year or even more.’ Greenblatt paints a picture ‘imagine an
investor diligently watching stocks specified by the magic formula doing worse
against the market average over the course of many months or even years, and finally
deciding enough is enough, no more formulas, and the investor goes on investing
in the market after his own investigation, only a few days after buying the
shares; after own investigation, investor notices that they are doing very
badly. Later investor will realize that the badly behaving stocks specified by
the magic formula will be doing greater than the stock the investor picked.’
According to the author ‘in the long run the magic formula is always correct.’
Chapter 9
In the chapter author tries to highlight the point why
magic formula makes sense?’ In answering this Greenblatt say ‘the magic formula
chooses companies through a ranking system; both high return on capital and
high earnings yield, i.e. magic formula helps in finding above average
companies than can be bought at below average prices.’ In elaborating on this
point author specifies that ‘companies that earn a high return on capital may
also have the opportunity to invest some or all of their profit at high rate of
return – this is very valuable and can contribute to high rate of earning
growth. And companies that achieve a high return on capital are likely to have
a special advantage of some kind and this special advantage keeps competitions
from destroying the ability to earn above average profit. In the same way, by eliminating
companies that earn ordinary or poor return on capital, the magic formula
starts with a group of companies that have a high return on capital and then
tries to buy these above average companies at below average prices.
Chapter
10
In the chapter author talks about risks and specifies
that when thinking about risk it is better to know the following things: first,
what is the risk of losing money following that strategy over the long term?
Second, what is the risk that your chosen strategy will perform worse than
alternative strategy over the long term? Even against above given definition of
risk – magic formula strategy never loses money, i.e. the magic formula
strategy achieved better results with less risk than the market averages.
Greenblatt ends this chapter with the statement – ‘although over the short
term, Mr. Market may set stock prices based on emotions, over long term, it is
the value of the company that became most important to Mr. Market, meaning if
you buy shares at what you believe to be a bargain price and you are right, Mr.
Market will eventually agree and offer to buy these shares at a fair
price.’
Chapter 11
In the chapter Greenblatt talks to the investor who still
does not trust the magic formula and wants to ‘pick stocks all by themselves.’
Author actually encourages investor to use ‘it; magic formula, merely as one
tool in the toolbox and use it as a filter and to eliminate bad stocks, then
just pick from among the top ones from the formula. The overwhelming message of
this chapter is that as Greenblatt say ‘most people have no business investing
in individual stocks on their own.’ Author also re-emphasizes that picking
winning stocks is even difficult for the big professional money managers.
Chapter 12
Author stresses the point that ‘money won’t magically
appear under your pillow, and once you have left the warmth and comfort of your
home, you are on our own.’ Thereon Greenblatt goes on to explain different ways
‘how an investor can invest in the stock market like mutual funds, hedge funds,
and index funds. Each of the above mentioned according to the author has their
positive and negative points. By the end of the chapter Greenblatt once again states
that ‘by applying in the magic formula you can achieve extraordinary long term
investment return and that you can achieve those returns with low risk.’
Chapter 13
Greenblatt ends the book with the firm belief that - ‘I believe
that using the magic formula and the principle behind the magic formula to
guide your future investment will remain one of your best investment
alternative. I believe that if you are able to stick with the magic formula
strategy through good period and bad, you will handsomely beat the market
average over time. In short, I believe that even after everyone knows the magic
formula, your results will continue to be not only quite satisfactory, but with
a little luck extraordinary.’ In the final pages of the book ‘appendix’ author
lays out how to apply magic formula, with the help of website.
Final
thoughts
This great book, written in straight forward and
accessible style, is in truth an introduction on how to pick stock and reveals
Greenblatt’s time tested formula that makes buying above average companies at
below average price automatic.
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