The Little Book That Beats The Market: Appendix

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.

For those convinced that the investment strategy encouraged by the book is a good one to follow, Greenblatt offers step by step instructions at the end of the book.

1) Go to magicformulainvesting.com

2) Follow the instructions for company size

3) Follow the instructions for a list of top-ranked magic formula companies

4) Buy 5-7 companies.

5) Repeat steps 1 to 4 every 2-3 months, which should give you 20-30 stocks for the year.

6) Sell each stock after holding for one year

7) Continue for many years. It's important to stick to the strategy, otherwise you may quit before it gets a chance to work.

Greenblatt ends the appendix with a discussion of the efficient market hypothesis, which suggests that the market is priced efficiently. While many studies have shown that various different strategies can beat the market, they have often suffered criticism for overlooking various aspects, such as increased risk, survivorship or look-ahead bias. Greenblatt asserts that the magic formula does not suffer from any of these biases, and works well for both large and small stocks.

The Little Book That Beats The Market: Chapter 13

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.

While he cannot guarantee the results of the magic formula going forward, Greenblatt does believe that using it over the long-term will provide investors with excellent returns. But despite the money that can be accrued following this technique, Greenblatt doesn't believe this type of investing adds any value to society.

While the stock market does provide a valuable service, creating a secondary market that allows the primary market to raise capital for companies that need it to grow, Greenblatt believes that 95% of the trades out there are completely unnecessary to serve this purpose. For this reason, Greenblatt makes the case that investors who profit from this formula should use some of those profits for purposes that do benefit society.

In particular, Greenblatt argues that the education system needs help. Education is the foundation for the high-level work force that helps the economy thrive. But much potential is wasted. In every major US city, only half of public school ninth graders end up graduating from high school.

In a capitalist system, capital moves from poor businesses to productive businesses, and that's what helps the economy thrive. In the school system, however, it is very difficult to close poorly performing schools and stop paying teachers that can't get the job done, in order to divert capital to better performing schools/teachers. Greenblatt argues that this issue needs to be addressed, and provides the reader with some means to do so.

The Little Book That Beats The Market: Chapter 12

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.

In this chapter, Greenblatt warns about the pitfalls of following some of the other investment options that are available to individual investors.

First off, individuals may get direct stock advice from stockbrokers. While stockbrokers can help explain some elements of investing and probably do want you to succeed in the long term, investors must keep in mind that brokers make their money by selling something to the investor, not by the long term success of the investor.

Rather than relying on a broker, mutual funds or hedge funds offer a better alternative, because they are motivated by track record to a larger extent. Nevertheless, these funds make more money by becoming larger and larger (so they can charge fees for the size of the assets under management), which makes it more and more difficult to maintain strong levels of performance. Furthermore, after fees, most of these funds are bested by the market.

While there are good managers out there that can beat the market, there are many more who will not. Just as the magic formula can lose to the market in three-year periods, so too can good money managers. In the same way, poor managers can beat the markets over periods of such length. As such, it very difficult to identify a fund manager with whom one should invest.

Investing in index funds is therefore an option which allows investors to closely match the market's return. But that's all the investor can do with such funds: match the market. To beat the market, investor's should use the magic formula.

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).

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.

The Little Book That Beats The Market: Chapters 8 and 9

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.

While the Magic Formula appears to work over the long-term, Greenblatt discusses reasons why it is not used by everybody. He considers it good news that the formula doesn't work in many periods, as this prevents people from exploiting it and thus reducing its returns.

For example, the formula is outperformed by the market in 5 months out of every 12 (for the 17 year period Greenblatt tested). It can even underperform for years in a row, as at one point in the simulation it underperformed for three years in a row. This makes it very difficult for fund managers to employ it consistently. Greenblatt cites examples of various value fund managers he knows who lost large chunks of clients or who even closed down shop after underperforming for years, only to eventually emerge with far superior returns in the long run. The pressure on fund managers not to underperform their peers forces them to make decisions that are not in the best interests of their funds in the long term.

But to be able to stick to the formula, Greenblatt argues that investors must understand why it works. The bottom line is that by employing the formula, investors are buying stocks with the best combination of returns on capital and earnings yield. High returns on capital suggest a business has an advantage or position which allows it to make abnormally high profits, and a high earnings yield means investors are paying relatively less to buy each dollar of earnings. This combination is logical, and so it makes sense that the formula would work in the long-term.

The Little Book That Beats The Market: Chapter 7

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.

In this chapter, Greenblatt speaks to the skeptic who doesn't believe the formula described in the last chapter. To that end, Greenblatt identifies possible pitfalls of using the formula, and attempts to disprove them.

First, he uses the past data to ascertain whether these results could indeed have been realized. For example, if the formula only showed great results because the simulation model used prices of small, illiquid stocks, then it may not be very useful. But Greenblatt ran the formula against markets of all sizes, and found that it beats the markets handily even among large caps.

Second, Greenblatt discusses whether the formula could have been lucky. After all, one could use historical data to come up with several winning strategies, but that doesn't mean they will work going forward, as they could be the result of coincidence. Considering the size of the sample Greenblatt employed (number of stocks over number of years), he does not believe the formula to work as a result of luck.

Finally, another possibility is that the market could wise up going forward, and no longer offer the top 30 stocks (as ranked by the formula) at such a large discount. If those 30 are no longer available, is the formula useless? To counter this theory, Greenblatt divided the stock universe (in his study) into deciles. He found that the deciles outperformed each other exactly as expected. In other words, the 4th ranked decile outperformed the 5th ranked decile, the 5th ranked decile outperformed the 6th ranked decile etc. This suggests the formula works on the general market, and does not require a special group of 30 mispriced securities (which is considered the 1st decile).

The Little Book That Beats The Market: Chapters 5 and 6

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.

In these chapters, Greenblatt introduces two concepts which form the foundation of the Magic Formula: earnings yield, and return on capital.

Earnings yield is simply earnings divided by price. If a company was for sale at a certain price, a buyer would hope its earnings are high (relative to the price), not low. As such, a high earnings yield (or conversely, a low P/E) is desirable.

Return on capital is the money that a company receives from investing its own money. A company that can generate a higher return on capital is more desirable than a company that generates a low return on capital. A company that generates a return on capital less than the risk free rate is actually destroying capital.

By owning businesses that trade at high earnings yields and that have high returns on capital, investors will beat the market. To demonstrate this, Greenblatt examined the results of owning approximately 30 stocks with the best combination of earnings yield and return on capital over the last 17 years (since that's how far back the Compustat "Point in Time" database went back). The portfolio returned 30.8% per year, compared to 12.3% for the overall market.

How were these portfolios constructed? All stocks in the market were ranked by the two criteria described above. The rankings were then added together. The top 30 combined-ranking stocks were considered the portfolio for the purposes of this study.

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.

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.