The Big Secret for the Small Investor

These are my notes from Joel Greenblatt's The Big Secret for the Small Investor:

Tl;dr

• The key to successful investing is to figure out the value of something and then pay a lot less

• Figuring out the value of something requires you to predict future earnings and future interest rates

• It’s pretty much impossible to predict future earnings and future interest rates

• The way to deal with this problem is to invest in (i) good businesses that you understand, (ii) that are likely to yield more significantly more than 6% per year, and (iii) are better than any other alternatives that you can find.

Solid Quotes

• “What strategy do you use to beat Tiger Woods? Don’t play him in golf.”

• “How do you keep an idiot in suspense?”

• John Maynard Keynes: “As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”

Book Notes

• The key to successful investing is to figure out the value of something and then pay a lot less

• The value of a business comes from how much the business can earn over its lifetime

• Earnings over the next quarter or next year are only a small portion of its value

• To value a business you need to know what the future earnings are going to be and what the interest rate is going to be (i.e. to discount those earnings by)

• But we don’t know either of those things. Even a small miscalculation in our estimates compounded over many years can result in huge swings. So how do we deal with that?

• There are a few other valuation methods:

  • Relative value i.e. how much are similar companies valued at? This is helpful but flawed e.g. what happens when all similar companies are overvalued and in a bubble? Everything is overvalued.

  • Acquisition value i.e. what is the company worth to someone else?

  • Liquidation value i.e. what is the sum-of-the-parts of the business if we look at its assets and not just its earnings

• None of these valuation methods are good. So what do we do?

• Start with the assumption that there are other alternatives for our money. The main competition any investment has to beat is how much money it could earn “risk-free”. It’s safe to assume 6% as the “risk free” rate for a 10-year bond (although of course it can fluctuate around that)

• Now we have a standard by which to compare all other investment decisions

• If we are very confident an investment will offer a significantly higher return than 6% than we cleared the first hurdle

• The second hurdle is to compare it to other investment alternatives we can find

• When evaluating investment alternatives don’t play hard games or invest into uncertainty. Only invest in investments you can understand. There’s many fish in the pond.

• On non-consensus / Value strategies

  • Value strategies work because you are systematically setting yourself up to buy things others don’t want . E.g. buying shares in smaller companies where bigger players don’t play.

  • Knowing where to look, rather than extraordinary talent, is the most important part of finding bargains.

  • To beat the market you must invest different than the market

  • A fund’s twentieth or fiftieth pick doesn't add a whole lot of value to the portfolio

  • In the short term stock prices can reflect emotions more than value. “Be fearful when others are greedy and greedy when others are fearful.”

  • Winning strategies deviate from the market. All good managers go through periods of underperformance. Almost all investors run from underperformance.

• On portfolio concentration and investing in what you understand…

  • John Maynard Keynes: “As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”

  • Warren Buffett: “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”

• Investors can lose money in the best performing funds just by buying the fund at the wrong time

• By the time we figure out who the good managers are, they’re probably accumulated large sums and aren’t able to pursue the strategies that made them successful.

• The long term value of a business can’t possibly change as often and as drastic and changes in the stock price indicate

• It may be harder to pick a good stock picker than to pick a good stock

• Market cap weighted index funds have a larger weighting in stocks that increase in value and smaller weighting in stocks that decrease in value. As Mr. Market gets overly excited about certain companies, funds allocate more of the fund toward them. Funds in effect then own less of bargains and more of expensive companies. Weighting by market cap will ensure we buy too much of overpriced companies and too little of underpriced companies. Equally weighted indexes would perform better than capitalization weighted funds.

• Look for companies that can invest earnings at high rates of return

• Time arbitrage: looking out and focusing on the long term when everyone else is focused on near term issues