The Little Book That Beats the Market

These are my notes from Joel Greenblatt's The Little Book That Beats the Market:

Editor's Note

I haven’t found a critical analysis of the Magic Formula that has provided evidence of underperformance. Most of the analyses I’ve read point out smaller overperformance than the book claims. For example, Reasonable Deviations backtested the Magic Formula and found an annual 3% alpha, which is still considerable. If you know of any good reviews of the Magic Formula let me know! You can reach me on Twitter or email me at monk (dot) ephraim (at) gmail (dot) com.

Tl;dr

• It’s possible to beat the market despite what efficient market theorists say

• You can beat the market by buying (a) above average companies at (b) below average prices

• The Magic Formula uses (a) Earnings Yield to find bargains and (b) Return on Capital to find quality

• You can’t predict the future. The less we pay for good companies today the less we need to accurately predict the future.

Solid Quotes

“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.”

Notes

• Stock prices move around wildly every day and sometimes fluctuate 50% to 100% or more in any given year. But does that really mean the value of the company changed?

  • Why then do share prices move around so much when the actual value of the companies do not?

  • There’s a lot of potential reasons but basically “people go nuts”.

  • They get excited, depressed, scared, etc. The reason doesn’t matter. What matters is that sometimes Mr. Market charges too much and sometimes he charges too little.

• Our job is to buy good companies when Mr Market is selling them at a steep discount.

  • But how do I know (a) when a company is good and (b) when a good company is trading at a discount?

  • We look at two metrics:

    • Earnings Yield

      • Measures how much we get relative to what we pay

      • We are looking for bargain prices i.e. high earnings yield

      • Technically measured by EBIT/EV

    • Return on Capital

      • Measures how much the business needs to invest to produce earnings

      • The less it has to invest to produce earnings the higher quality it is

      • Technically measured by EBIT/(Net Working Capital + Net Fixed Assets)

    • The Magic Formula uses EBIT to remove distortions of taxes and debt which vary among firms

      • EBIT = EBITDA - Maintenance Cap/Expenditures

• We can’t predict the future.

  • You don’t want to be in that business. And you don’t need to be in that business. You want to invest in a way that minimizes the need to make predictions.

  • If you are buying businesses at low prices you don’t need to do the same complex evaluation about the future.

• The Magic Formula is about systematically selecting stocks with best combination of earning yield and return on capital

  • Magic Formula produces better returns with less risk

  • Magic Formula beat the market 95% of the time over various 3-year periods and was at least breakeven.

  • Magic Formula's worst return was -11% vs. -46% for the market

  • Magic Formula led to 30.8% annualized return over 17 years vs 12.3% for the overall market

• Why don’t others copy the strategy and arbitrage away profit?

  • Magic Formula doesn’t work every year so people don’t stick with it.

  • Their investment time horizons are too short.

  • It works over the years not necessary in any given year

• Mr Market is emotional in the short term but he gets right in the long term.

  • Either catalyzed because the market catches on to a good businesses trading a discount, management will buyback their shares, or another company will spot the opportunity and acquire the business

• Investing earnings at above average rates of return is the gold standard

  • Most people can only invest into average rates of return.

  • Investing into above average rates of return is something special.

  • These types of good business that lead to above average returns attract competition

  • So there must be something special going on if return rates are high because that means no one else competed them away

  • There is a possible “value trap” in companies earning an above average returns trading at discounts. E.g. a patent could be expiring. Need to suss out if Mr. Market is missing it or if you’re missing a value-trap

• How the Magic Formula Works

  • Pick 10 to 30 stocks from the magic formula screen

  • Hold them for 1 year

    • Sell losses just before 1 year (to get short term tax treatment)

    • Sell gains 1 day after 1 year (to get long term tax treatment)

  • Add a few stocks a month as you grow into the 10 to 30 you select. Follow a first in first out method.

• For general screens that approximate Magic Formula

  • Look for Return on Assets of 25% and take the lowest PE issues

  • Be careful of unusually low PEs because something wonky might be going on