Sunday, October 25, 2009

The Little Book That Beats The Market: Chapter 11

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.

Despite the fact that the magic formula beats the market handily, Greenblatt recognizes that there are those who will not be satisfied with simply buying the basket of 20-30 stocks the formula spits out. This chapter offers advice to those individual investors who can't help but to pick stocks on their own.

Greenblatt starts with a warning:

"Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot."

After the warning, Greenblatt goes on to discuss some of the weaknesses of the formula, and how investors who do know what they're doing can improve their results.

For one thing, the formula considers last year's earnings when computing both the earnings yield and the return on capital. But last year may not be indicative of the company's earnings power, due to unusual occurrences. Therefore, Greenblatt suggests that people who know what they are doing can calculate 'normal' earnings for a company, and use that as a basis for earnings yield and return on capital, rather than simply using last year's earnings.

Even though the concept is simple enough, Greenblatt argues that predicting normal earnings is very difficult, and only those who know what they are doing should try it. As it stands, the magic formula works just fine even though it uses last year's earnings. This suggests that last year's earnings are reasonably indicative of earnings when a large enough basket of stocks is employed.

But for those who are capable of understanding the businesses they research and determining normal earnings, Greenblatt recommends a much smaller basket of companies. In fact, Greenblatt advises a basket of just 5 to 8 companies (as opposed to the 20-30 recommended for those using the magic formula) for those who know what they are doing.

So far, that covers those who know what they are doing and those who do not. But Greenblatt also has advice for those who don't know if they know what they are doing, but still want to choose individual stocks! For this group, Greenblatt suggests choosing between 10 to 30 stocks from the top 100 companies produced by the magic formula (as opposed to just choosing the top 30 stocks).

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