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Author Topic: Book Review - The Little Book that Still Beats the Market  (Read 807 times)
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Capitalist Pig
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« on: 2011 Mar 19, 01:29:15 pm »

As I mentioned a few months ago in Cash is King - Why You Need to be Ready When Opportunity Strikes, I picked up a bunch of business and investing books for cheap.

Well, I finally got around to reading The Little Book That Still Beats the Market this past week. I have to say, it was pretty good.

In it, Joel Greenblatt outlines a very simple and elegant value investment strategy. For those who don't know, value investing is the investment approach that looks for quality companies that are being discounted today because of some extreme in the market. Benjamin Graham is generally considered the originator of this concept, and his student, Warren Buffet, is its most famous practitioner. Greenblatt's argument is essentially that Graham's formulas don't work particularly well any more because when the were developed, the market was still climbing out of the depression of the 30s and 40s. Stocks are no longer as cheap as they once were based on Graham's formulas, so we need to look for different criteria of value.

In general, this makes sense. Graham's formula is based on the most recent 12 months of earnings and a 7-10 year growth rate. As we've seen though, earnings can be massively manipulated and a 7-10 year growth rate is extremely difficult to predict in these times. So Greenblatt takes two different measurements, return on capital and earnings yield to evaluate companies. Those companies that rank highest in an ordered list for both are the highest value companies.

He then goes through some applications of this "magic formula" from 1988 - 2009, and indeed the results are impressive. He calculates that picking 20 or 30 of the best from such a list each month, holding a year and then selling would yield a return of about 22%/year. Of course, there are a few problems.

The first problem is that there are entire years where this strategy doesn't work. Basically his advice is be patient, it'll work out in the long term. Really this is just a fact of life. Things don't always work out perfectly. You have to deal with the hard times to get to the good times.

The second problem, and this is just my opinion, is that holding for a year is entirely arbitrary. If you are buying based on value, then it would make much more sense to me to sell based on value. Let's say you have the ordered list of stocks in the market, and you buy the best value available. Wouldn't it make sense to sell when that stock has moved to the lower half (or some other level you like) in the list?

The third (bonus!) problem is that this is not an investment strategy. It is a long-term trading strategy. People have confused the two terms for many years. Trading is simply buying something at one price, selling at another, and hoping that you made money. You can trade almost anything. Investment is putting money to work where it will earn a yield over time. This confusion leads people to be very upset when things don't go their way. If you think you invested then you should get a return, and rightfully so. When you actually were trading money for stocks and stocks for money, but thought you were investing, you can be set up for great disappointment. I'm not saying there is anything wrong with trading, it is what makes the world go 'round. I'm only saying that you should be aware of what you are doing.

Overall, Greenblatt is an engaging writer who has a solid trading idea here. I think it's worthwhile for anyone in the stock markets to read. I'd change a few things like problem #2 and instead of adding the ranks, I'd use the Pythagorean formula from an origin to find each stock's distance from said origin, but these are tweaks. If you want a once-a-month set-it-and-forget-it kind of approach, this might work out very well for you.

* Book_new.small(1).jpg (11.97 KB, 125x177 - viewed 1438 times.)

Neal McSpadden
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