Interesting little book

Shit, it’s been ages since I wrote. For the few that remotely care, sorry! Life’s been insanely busy over the last several weeks. I finally managed to make time to read as well, and am intrigued enough to write about the book I read.

Among my pet hates are 3 categories of books - those that tell the reader how to (1) lose weight, (2) be happy and (3) make more money. I view such books as a general attempt to swindle readers. The first category says ‘eat right, move your butt’ in various lengthy ways. On the second, if you can afford to buy a self-help book, you’re doing fairly ok to start with. Look around at the less fortunate, stop whining and be happy with what you have. The third typically goes down the ‘buy low, sell high’ route and are mostly written by people who weren’t that successful at making money anyway (or else, why’d they need to write such books for a living). Given my prejudice, when my colleague – Rob Stavis – sent across a book titled ‘The Little Book That Beats The Market’, my initial reaction was skeptical. Stavis himself ran arbitrage trading for Salomon Smith Barney, and knows a thing or two about beating the market. This book ia authored by Joel Greenblatt, whose hedge fund – Gotham Capital – has delivered over 40% annualized returns over a 20-year period! Further, the book didn’t look intimidating at all. In fact, it is a 150-page pocketbook that can be completed in one sitting.

I am really intrigued by what Greenblatt writes in this book. The central thesis is ‘buying good businesses at bargain prices is the secret to making lots of money’. Sure, that’s obvious. Greenblatt then goes on to propose a simple ‘magic formula’ to identify good businesses that are available at bargain prices. The two metrics he uses are:

1. Good business = one that generates high return on capital, as measured by EBIT/(net working capital + net fixed assets)

2. Bargain price = high earnings yield, as measured by EBIT/(market value of equity + net interest bearing debt).

EBIT stands for Earnings Before Interest & Taxes or pre-tax operating earnings. Note that both of these metrics do NOT require any estimates or projections, and are measured purely using past data (last 12-months EBIT & current balance sheet, equity values). All one needs to do is rank all listed companies on these 2 metrics, and invest in those that have a high rank on both counts.

This may sound very simplistic, but wait till you see the results. Greenblatt applied this ‘magic formula’ to a 17-year period from 1988 to 2004, and created a hypothetical portfolio of top-30 stocks that this formula throws out (the portfolio is juggled once a year, using the same formula). Such a portfolio would have generated annual returns of 30.8% over this 17-year period, compared to 12.4% for the S&P 500! Greenblatt goes on to perform various statistical tests, to show that this super-performance isn’t due to luck or some statistical aberration, and that the formula works across different scenarios. It may always be possible to find specific companies that rank poorly on these metrics, but go on to make spectacular stock returns. However, at a portfolio level (say, 20-30 stocks or more), this formula outperforms the market by a margin that’s doesn’t leave much reason for doubt.

This is the kind of book that left me scratching my head, with tons of questions (but, doesn’t the value of a firm depend on future earnings & growth?). At the same time, I cannot deny that this seems to work really well, in the face of hard data.

I’d encourage you to read the book, visit www.magicformulainvesting.com and enlighten me if you have any more insights on this matter.