Saturday, October 24, 2009

The Little Book That Beats The Market: Chapter 10

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.

Greenblatt discusses the risk and return of the magic portfolio over the 17 years of historical data that he looked at. In some years (about 1 out of every 4), the magic formula underperformed the market. Over two-year periods, however, the magic formula improved its odds for beating the market, as it only failed to do so about 1 in 6 times. Over three-year periods, the magic formula never lost money and outperformed the market 95% of the time.

For this reason, Greenblatt argues that the magic formula operates with a low level of risk from the perspective of long-term investors. He rejects other measures of risk commonly used in the finance industry (e.g. standard deviation of returns), and instead chooses to measure risk by answering the following two questions:

1) What is the risk of losing money in the long-term, following the strategy?
2) What is the risk that this strategy will perform worse than the alternative strategies?

While the logic of the magic formula has been discussed in previous chapters, Greenblatt feels it necessary to assure the reader that stock prices do converge to the values of the underlying businesses in the long-term. Most of the time, this convergence takes place within 2 or 3 years. Sometimes, it can take weeks or months, while other times it can take years.

Some of the reasons prices will eventually converge to their values are: firm buyouts, other investors who see value, share buybacks etc. Greenblatt argues that in the short-term, Mr. Market can be quite emotional and offer crazy prices, but in the long-term he is mostly right.

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