The Little Book that Still Beats the Market The Little Book that Still beats the Market is a short piece of writing that presents clear and simple explanations of the basics of investing and how the stock market works. Through his years of experience and expertise, Joel Greenblatt has constructed a “magic formula” that promises to deliver above-average returns on your investment in the long run. In this paper, I will discuss several topics that include: a summary of the book, what I found most exciting about the book, the magic formula and several stocks that I picked out using the magic formula investing ebsite.
To open up the book, Greenblatt illustrates a situation in which a boy at school sells bubble gum to his peers at school. This situation then evolves to a point in which the Greenblatt and the young school boy are trying to determine the value of his business. We soon learn that determining the value of any business is the first step in efficiently investing. Greenblatt briefly covers the different ways in which one can store their money. Several options included: a mattress, the bank, the government or individual firms. The idea of putting your money under your mattress is by far, the worst option possible.
This is because the money under your mattress does not collect any interest, nor does it elude the cost of inflation. A more efficient way to invest your money is to do it through the government, bank or corporation. All of these choices are superior for a few reasons. If you chose to put your money into the bank, the Federal Deposit Insurance Corporation (FDIC) will insure your account for up to $250,000. This is a pretty safe investment considering the guarantee of the FDIC and he solid interest rate provided by the bank.
However, the safest investment is to put money into the government. This is because are permitted to print money and collect taxes and therefore considered risk free. If you are feeling a bit more risky or want an interest rate much higher than what the government or banks can offer, then you can invest into stocks or bonds of a business. These companies offer higher interest rates due to the increase in risk and the uncertainty of the future. Next, the author introduces the important concept of ‘Mr. Market’. Originally reated by Benjamin Graham, Mr.
Market is a bipolar partner in your business that, everyday offers to sell his share of the business to you or buy your share of the business for the same price. The problem is that Mr. Market changes his offer every day. In result, we must determine when the best time to sell or buy is, based up on his offer and your valuation of the business. In essence, this is how the stock market works. Taking the time out to read this book was without question, time well spent. I was very skeptical of the book when I first picked it up.
Like they say, anything that sounds too good to be true, usually is. But after reading the book, I have developed a much larger understanding of picking stocks and investing as a whole. This book not only includes a magic formula decrypted in plain sight for all to see, but also contains simple language and a clear thought process for the reader to follow. I particularly enjoyed this book due to the passion I have for this field of study. Being able to to utilize this magic formula in my own personal finances – or at least in the screening process.
Now getting into more of the philosophy side of investing, we learn two important concepts that, when combined provide the foundation for the magic formula. You would rather have a higher earnings yield than a lower one. ‘ If a firm has a high return on capital, this usually indicates that the firm is highly efficient and has a great money sense. The second concept is that you would rather own a business that earns a high return on capital that one that earns a lower return on capital’. The reasoning behind this is that if a company has a low price earnings ratio, this asically means that the business is being traded at a relatively low rate.
The magic formula tells us to combine these two concepts to find value. Greenblatt goes on to say that all we have to do in order to make a fortune is to rank all these companies by their price earnings ratio, their return on capital, combine the scores and simply invest in the top thirty. Easier than it seems, but the reason why this works is because on average, we are purchasing good companies that have high returns on capital, but only when they are available at cheap prices. This formula appears to be bullet proof so far, but unfortunately, it has its limitations.
The author tells us that in individual years, the formula doesn’t do too well and will often be lower than the market average. However, Greenblatt argues that the formula only really works over a long term period and if you stick with it, then it will be highly rewarding. It is because of this long term waiting, that many people receive adverse results and feel that this formula is flawed. Another limitation of this magic formula is the fact that it does not take into ccount, all the external influences that affect business activity.
These include, but are not limited to: recessions, quality of products/services, value of brands, government and legislation, etc. This formula also does not take the value of future cash flows into consideration when evaluating a company. Based upon the evidence and despite all of its flaws, this magic formula seems to be a great way in which one can invest their money. However, this person must be committed to the long term growth of these companies and cannot be deterred from this strategy.