Imation (IMN) is a 1996 spin-off of the innovative 3M Company (MMM) that produces storage media from DVDs to backup tapes. It owns the #1 brand/sales position in many of the segments in which it competes. Unfortunately, it doesn't generate returns on equity anywhere near 3M, but on the other hand it doesn't trade at a massive premium to its book value either. Imation has equity of over $900 million but trades for just over $300 million.

With some noted exceptions, companies trading with such low price to book ratios are not likely to be profitable or they wouldn't trade at such low levels. Imation is no anomaly in this regard. Due to various restructuring, pension, asset impairment and litigation charges, along with the current recession, Imation hasn't been profitable for the better part of three years. But last quarter, even including the charges, Imation managed to eke out a small profit, which could suggest they are making progress in aligning costs with revenues.

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.

Click here for summaries of chapters 1-7, 8-11, 12 & 13

A company that makes for a good investment for one value investor does not necessarily make for a good investment for another value investor. How can this be? A company may appear cheap on an earnings or asset basis, but future earnings may not live up to current earnings and assets may be written down. Therefore, only when a company falls within an investor's circle of competence can he ascertain whether a stock is trading at a discount.

Consider ADDvantage Technologies (AEY), a hardware provider for the cable television industry. The company is cheap on many metrics, trading near its net current asset value with a P/B of 0.75 and a P/E of 6. Though sales have fallen dramatically through this downturn, the company has maintained profitability.

As the market has risen throughout most of this year, many market observers have noted that P/E values are looking rather inflated from a historical standpoint. But of course, earnings are lower than usual this year due to reduced revenue that was caused by financial shocks. So as investors, should we be willing to pay a higher P/E for now, on the assumption that earnings will soon pick up?

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid, and will therefore be unable to adapt to a lower revenue environment. Other companies, on the other hand, will have flexible cost structures or will see revenue continue to grow, despite the downturn. But to determine which of these forces will exert more pull on the market's earnings in the coming quarters is not only extremely difficult, but unnecessary: Unless you're trying to value the entire index, you don't have to answer this question for the market in the aggregate. Instead, you can try to answer this question for individual securities, which are much easier to understand.

Contrary to popular belief, increases in aggregate spending (e.g. consumer spending) is not what leads us to a higher standard of living. Nevertheless, both in good times and bad, consumer spending is the gauge the media focuses on as a barometer of how we're doing; but consumer spending is only a measure of short-term demand. Increases in standard of living, however, come from our ability to do our jobs more efficiently.

For example, consider a plant that employs 1000 workers and makes one widget per day. Suppose one day the plant manager comes up with a new method of making that widget, and only requires 500 workers to do it. The remaining workers just got richer, because now the revenue from the widgets sold is spread over fewer workers. (In practice, of course, this process would take time, and the higher profits would be shared among owners and laborers through market forces. Furthermore, the 500 laid off workers would undergo short-term difficulties until they could join a company that's expanding.)

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.

Chapter 12: Choosing a broker/fund manager

When Circuit City declared bankruptcy near the beginning of the recession, opportunities were created for other electronics retailers. One company that aggressively stepped forward to fill the void is Conn's Inc. (CONN), a home appliance and electronics retailer. Conn's even took over some of Circuit City's previous locations on its quest of aggressively growing its market share.

We looked here at the Dow Jones Industrial Average, and saw why it's not a great measure of U.S. stock performance, despite being a favourite index when it comes to media coverage. The S&P 500 is a much better barometer for the health of U.S. stocks, though an understanding of its calculation methodology is important in order to understand the limits to its usefulness.

The S&P 500 is essentially a market-value weighted index*, meaning a company's influence on the index is proportional to its size. This is much different than how the Dow Jones Industrial Average is calculated. Also unlike the Dow, the 500 stocks that comprise the index are chosen such that the index proportionally represents the economy's various industries. As such, the S&P 500 is not just the 500 largest companies. One interesting note is that despite being larger than almost every company in the index, Berkshire Hathaway (BRK.A) is not a component of the S&P 500.

At times, value investing can feel like trading. While value investors should always purchase with the expectation that a stock will be a long-term holding, some stocks can be so volatile that they go from offering a margin of safety to offering a reasonable price and back again within the span of a few weeks! And as Warren Buffett told us when we met with him last year, volatility (shunned as an undesired property by the mainstream finance industry) is the friend of the value investor.

For example, earlier this month we discussed how LCA Vision (LCAV) may have appreciated to a conservative estimate of its intrinsic value. But just three weeks following that article, its price had fallen by 40%, offering investors the opportunity to buy back in at depressed values!

Ridley Inc. (RCL) manufactures and sells animal nutrition products to North American meat, milk and egg producers. As such, it operates in a fairly stable industry, as demand for many feed products tends to hold steady through recessions.

Despite the stability of this industry, and Ridley's role as one of the larger players with $600 million of annual sales, the company is conservatively capitalized with only $13 million of debt compared to equity of $150 million. Meanwhile, the company trades for just $100 million, while it has brought in combined operating cash flow of over $60 million over the last four years.

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

The herd mentality is well-documented outside the investment world. While it is not given much thought within the investment world (exceptions include discussions on the topic from both Ben Graham and Stephen Jarislowsky), it plays a large role in the investment decision-making process: investors feel much more comfortable buying stocks when they believe that others are also piling in. To that end, investors often rely on analysts, who are expected to be "experts" in guiding investors on stock selection

But just how good are analysts at predicting the directions of stocks? A decent paper (though dated) is available here which discusses the difficulties in truly evaluating analysts. However, at the very least, if analysts were at all useful, they should be able to tell the difference between a company that has value and one that is about to go bankrupt. Yet these two very different realities in a company's status continue to baffle these "experts".

Once again, Apple (AAPL) impressed investors with results that handily beat analyst expectations. The company continued to move iPods en masse, and sold a record number of Mac computers and iPhones, staunchly defying the drag on consumer spending that has been the bane of this economy.

There can be little doubt that Apple is a well-run, exceedingly competent company. That much can be determined with a quick look at the company's financial statements, where equity returns of around 25% are commonplace. What makes those returns even more impressive is the fact that no leverage is employed in garnering these exceptional returns: Apple has no debt!

Companies are required to release their financial results according to GAAP. Often, however, companies will also release what they call "Pro Forma" statements, where certain "one-time" costs are often removed. These statements, managements say, better reflect the earnings power of the company. However, investors are urged not to take management's word, but rather to consider the "one-time" costs to make their own determinations as to whether these apply in the future.

For example, managements have often excluded early plant retirement costs or losses on the sales of equipment from pro forma statements. While these items may not occur annually, the investor must apply business sense to determine if these are likely to re-occur.

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.

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!

Margin debt on the NYSE can be a useful indicator of how Mr. Market is feeling. If optimism is high, people tend to borrow more to buy stocks. Previously, we've seen how margin debt through the last recession fell mightily and did not return to its previous highs for several years. Through last year and the first part of this year, it looked like margin debt would follow a similar path.

In the last six months, however, investor appetite for risk appears to have returned, with margin debt making a small comeback. Here is a look at the use of margin debt on the NYSE through August of 2009: (Click to enlarge)