Saturday, October 10, 2009

The Little Book That Beats The Market: Chapter 4

Joel Greenblatt, the book's author, is a value investor extraordinaire and a professor at Columbia's business school. In the book, Greenblatt discusses and justifies the "Magic Formula", a stock selection method that allows individual investors to beat the market using value investing.

Every year, Greenblatt starts his first lecture to his graduate class at Columbia Business School in the same way. He asks students to yell out companies, and he subsequently looks up the 52-week lows and highs of these companies' stocks. For every company, he finds large differences between the highs and the lows. For example, in the year that preceded his publication of the book, the following companies could be purchased at the following prices:

General Electric: $29 to $53
General Motors: $30 to $68
Abercrombie: $15 to $33
IBM: $55 to $93

These stocks were not chosen because of their wild price swings. Instead, their price swings are typical of many companies on the stock market. In such a short period of time, how can it be that such large, well-recognized, widely owned companies fluctuate in value so dramatically? Did GM all of a sudden make half/twice as many cars as it did a few months ago? Unlikely.

There are entire fields devoted to figuring out why and how these fluctuations take place. Greenblatt argues that much academic effort has been expended trying to explain "why something that clearly makes no sense, actually makes sense."

Greenblatt doesn't care why it happens. The point is that it does, and that's what allows you to profit. He goes on to discuss Mr. Market, and how you should buy from Mr. Market when he is offering you bargains, and sell to Mr. Market when he offers you a good price.

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