Choosing individual stocks without any idea of what your looking for is like running through a dynamite factory with a burning match. You may life, but you’re still an idiot.Joel Greenblatt
The Little Book that Beats the Market | Joel Greenblatt
The Little Book that (still) beats the market is a guide to implementing a simple mathematical formula for deciding whether to buy a stock, in order to generate long term profit. Joel Greenblatt follows in Benjamin Grahams footsteps as a fundamental value investor, much in the same way as Warren Buffet. Just like Buffet, Greenblatt was able to produce seriously amazing returns; his investment firm produced over 40% annualised returns for over two decades running!
Greenblatt echoes the virtues of value investing that he learned from Graham; which means buying stock with high returns (on capital) whenever it is undervalued by the market, and therefore with good long term growth potential. Because it is under priced now, if you wait long enough it will go up to the average (or maybe beyond) meaning a gain for the value investor. The formula for working this out involves;
- Calculating earnings yield (quantitative, inverse of P/E ratio) to see if the company stock is good value. For reference, a P/E of 16.4, or earnings yield above 6% is generally accepted as the long term average.
- Calculating return on capital (quantitative) to see whether it is a good company or not. Grenblatt suggests 25% RoC as a minimum threshold.
- Ranking companies on these two factors combined (quantitative) to find
- Analysis of company fundamentals or warning signs (qualitative). Greenblatt suggests ruling out any company with a P/E below 5, as well as utility, financial and all ‘foreign’ stocks.
- Buy, hold and being patient over the long term
Whilst Greenblatt suggests long term as being one year, in my (humble and uneducated) opinion I prefer to side with Buffet, with long term in my vocabulary equating to buy and hold ‘forever’ (or at least 50+ years). I also understand his home bias and fear of foreign markets, however I feel my investment risk in these are mitigated through the diversity of my ETFs.
I like how Greenblatt explains the craziness of the stock market and how peoples irrational investing leads to market volatility – he uses a great explanation of a kid selling chewing gum (a confectionery business!) to make his points over his 13 chapters. In the end though, He sides with Buffett and encourages investors to consider index funds like Ultra low cost diversified stock market ETFs over trying to pick individual stocks.