Sunday, October 4, 2009

The Little Book That Beats The Market: Chapters 1, 2 and 3

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 starts the book with a discussion about buying a hypothetical business. Basically, the value of a business is the cash it is going to generate over its lifetime, with money that arrives in the future not quite being worth money in the present (since money in the present can be lent to the government for a "risk-free" return and therefore would be worth even more in the future). The concept of how much to pay for a business is briefly discussed. If a business is presumed to be worth $1500, then it makes no sense to pay $1500 for that business since you already have $1500 in hand!

In Chapter 2, Greenblatt discusses at the importance of saving and, at a high level, the various places individuals can store their cash. He discusses the various benefits and drawbacks to storing money in mattresses, banks, as loans to businesses and as stock in businesses.

In the third chapter, the reader is taken through an example income statement. The income of the company is then compared to the offering price for the company, and concepts like earnings yield are discussed. Greenblatt asserts that since the business has risk, the earnings yield should be higher than the risk-free rate (i.e. what the government would pay for your money). But of course, the income statement only looks at past data, but what's important is what the yield will be next year and beyond.

Greenblatt assures readers that discussion of the magic formula is coming up, but that these concepts had to be discussed first for the novice.

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