The Little Book that Beats the Market: Chapters 8-11

Joel Greenblatt, the author of The Little Book That Beats the Market, 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. Read Summaries of chapters 1-7 here.

Chapters 8 and 9: Understanding why the formula works

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.

Chapter 10: Risk, logic and Mr. Market's emotions

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.

Chapter 11: For those who don't know if they know what they are doing

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).