Joel Greenblatt’s The Little Book that Beats the Market

The Little Book That Beats the MarketThe Little Book That Beats the Market by Joel Greenblatt

My rating: 3 of 5 stars

 

 
Short, short, short Review: A worthwhile, little book that raises some big questions, The Little Book that Beats the Market is good a place as any to start reading about investments, but the research process shouldn’t end here. Read his advice, take it with a grain of salt, and cross-check his recommendations.

Anyone who’s browsed guides about investment has probably seen the genre’s hallmarks. The first subset evinces the same tone and mindset as late night infomercials, but instead perfectly roasted chicken you’re supposed to end up with market-trouncing returns on your portfolio. These tend to be shorter in length and punchier in tone, as if to make the idea of investing less intimidating. They suggest, with an anti-snob undertone, that you can beat all of those so-called experts by following a particular rule or formula or technique. (I imagine that there have been other variations, and that during the tech-stock bubble in the late 90s there were books about how tech stocks represented the future of the American economy and you should put all your money in companies like pets.com).

The second genre seems like a reaction against the first. The general tone here is much less optimistic; if smart wall street people motivated by massive incomes can’t beat the market, what chance do you have? Do you really expect to beat a Harvard MBA after an afternoon spent browsing Barnes and Noble’s investment section? All the data that seem to support magic formulas or secret techniques to beat the street are subject to hindsight and selection biases, anyway, and the only hard lesson might just be to avoid being duped by easy answers. Your own enthusiasm can be your worst enemy, so just be happy if you can preserve your capital (especially after inflation) and don’t get killed while hunting for outsized gains. At the most extreme, many of these books recommend that you put a set dollar amount toward a mutual fund that represents an entire exchange per month. That way you guard against your own enthusiasms, you minimize management costs, and you spread your risk across the entire market. Sure you’ll never beat the market, but matching it represents more of an accomplishment than you might think.

The third genre, and the one that makes most sense to me, is that there aren’t any easy answers, but that you can take some measures to make sure that you are investing reasonably. They aren’t about picking particular stocks at any given time, but rather about the underlying principals that make a stock attractive, whatever they may be. These authors tend to be very coy (Benjamin Graham described the returns from one of his most lucrative investments as “quite satisfactory”), and it’d be easy to dismiss them as insiders who keep their secrets to themselves if they didn’t, in fact, lay their investment decision making framework out for the reader, as complicated as it is.

So where does Joel Greenblatt’s The Little Book that Beats the Market fall in this range?

It’s firmly in the first category, but it has enough of the other two to make itself worthwhile. Its intentionally limited in scope. You could finish it in a few hours, which may or may not confirm for you the idea that the biggest and hardest to accept truths are the simplest, the very title plays on the childhood truism that big things come in small packages, and it even has the physical dimensions and size of a children’s book. That being said, the point of the book is to talk about some of those fundamental truths without resorting too much to charts or hardcore data analysis. As complicated as picking stocks can get, there are some fundamental ideas that the investor needs to start with, and TLBTBTM’s strength is that it is a very clever, logical presentation of these common sense assumptions: 1) a stock represents ownership of a business 2) a business is a more attractive buy if it’s priced cheaply compared to its earnings and 3) if a business can use relatively small amount of capital to generate a high rate of return, it is a good business. Put these three together and voila, it isn’t too hard to get an idea of an attractive stock. It takes a lot of the qualitative guesswork out of screening stocks, and it lends itself to a fairly straightforward methodology for ranking stocks: Take the earnings yield of a bunch of stocks and rank them, lowest to highest. Now rank those same stocks again, this time based on their returns on capital, highest to lowest. Combine the two rankings, and organize them from lowest composite score to highest. A high ranking here should represent a good business that it selling cheaply. Voila! You’re done!

But here’s where the book falls a little too far into first genre, the one that makes things sound a little easier than they may in fact be. Greenblatt literally calls his ranking system a magic formula, and he hits on the term more than often enough to bring to mind images of Ron Popeil selling units to make the perfect rotisserie chicken. He claims that, after the first run of his book, he was seized by a few doubts: what if his readers used his magic formula to pick stocks, but they got the math wrong? Or what if they got their numbers from dodgy sources? He solves this problem by providing a link to his website, which is essentially a black box stock screener that does the number research, number crunching, and ranking for you. Your only input is picking the minimum size of the companies you’re willing to invest in. It’s got a major benefit of taking the individual out of the equation—and I’ve got a gut feeling that Greenblatt is right when he says that most individuals will work against themselves if they try to pick their own stocks. And by the way, you can invest with his company, which will use the principals of the Magic Formula, if you have enough money.

Now if you’ve been reading investment books of the second, pessimistic type, alarm bells should be going off right now, and Greenblatt himself acknowledges this camp, if just for a second. At one point in the book he does remind the reader that “There ain’t no tooth fairy;” stock brokers, mutual fund managers, and hedge funds are all basically charging you for their services and the feeling of being in expert hands, when in fact there is very little evidence that they are able to get you the returns you are looking for. But isn’t Greenblatt also one of those people? The only difference is that he’s selling you a book instead of his services. And wait a second—doesn’t he have his own fund? Why should he be giving away his secret? Shouldn’t he keep it for himself? Are we supposed to believe that he’s letting his formula be known, and making it easy for everyone else to identify the same stocks that he is after? If there ain’t no tooth fairy, and we aren’t supposed to trust those slick wall street types trying to sell us their services, why are we supposed to spend $20 on a book when Greenblatt is very purposefully not giving us the mechanism and data sources that he’s using to generate the magic formula stock lists? He’s self-deprecating and all (he claims that he has high hopes to not lose too much money on this edition), but could the whole book be a weird loss leader that will get people with lots of money to invest with one of his ventures?

I’d like to think that Greenblatt really is looking out for the public welfare and for his long term reputation, and that he’s not recommending bum stocks to the hoi-polloi while he juices returns for his wealthy clients until he’s got enough money squirreled away to start his new life as a cabaret dancer in Rio. I’d be a little more inclined to trust him if he recommended some well known, independent sources I could use to verify his data. For the moment I’m willing to give him a shot, if just for the fact that he’d make a juicy target for a financial journalist. BUT I’m also looking at every stock his screener returns as best as I know how, and putting his recs and numbers up against what bits of intellectual framework I’ve managed to put in place (mostly other books on value investing, e.g. Janet Lowe’s Value Investing Made Easy).

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