Book Review: The Little Book That Beats The Market

"The Little Book That Beats The Market" by Joel Greenblatt is easily the investment book of the year. In fact, it's the best investment book that I've read in many years. In 130 pages, which can easily be read in a couple of hours, Greenblatt gives the reader a stunningly simple, crystal clear formula for beating (make that trouncing) the market that anyone -- and I mean anyone -- can follow.

Joel Greenblatt is a professor of securities analysis at Columbia University as well as the founder and managing partner of Gotham Capital, a hedge fund with average annualized returns of 40% for over twenty years. When it comes to great investors, he's among the best of the best.

Greenblatt has an entertaining and humorous writing style that makes each page fun to read. And, like most great teachers, he has a knack of explaining sophisticated financial concepts in a common sense, down-to-earth way that a sixth grader could easily understand and enjoy. In fact, the book begins with Greenblatt using Jason, an 11-year old boy with a chewing gum business as an example (he buys gum for 25 cents a pack and sells each stick at school for 25 cents for a $1 a pack profit).

He asks his young son, "Ben, if Jason offered to sell you half of his business, how much would you pay?" As Ben thinks about how much Jason's business might earn during his years in school, Greenblatt explains that evaluating the value of businesses so he can buy them a bargain price is what he does for a living.

"The Little Book That Beats The Market" is about how to find good businesses to buy at bargain prices. By buying shares of companies for much less than what they're worth you, the investor, will have a large "margin of safety" that will lead to safe and consistently profitable investments.

So the plan is to buy a percentage interest (shares) of good businesses at bargain prices. That's how to make a lot of money. How do you find these businesses? Are you going to have to learn how to pour over balance sheets and income statements and do sophisticated financial analysis? Not at all. And that's the beauty of the Little Book. Greenblatt gives you a simple "Magic Formula" that you can use to find great investment opportunities.

A good business is one that can invest its own money at a high rate of return. In other words, a good business is one that can earn a high return on capital. There is more than one way to determine return on capital. The formula that Greenblatt uses is operating profit as a percentage of net working capital and net fixed assets. The higher the return on capital the better the business.

So now you know how recognize a good business. But how do you know when a good business is being sold at a bargain price so you can make a lot of money? Greenblatt uses earnings yield to determine that. As with return on capital, there are various ways to determine earnings yield. Greenblatt uses operating profit as a percentage of enterprise value (market value of equity plus net interest-bearing debt). The higher the earnings yield the better the bargain.

The only Magic Formula you need to discover good companies selling at bargain prices is to find the ones with the best combination of a high return on capital and a high earnings yield. However, that still requires a certain amount of actual work (yikes!). And it requires a familiarity with terms like "operating profit," "working capital," "fixed assets," "enterprise value" and the like. So Greenblatt has even made that part easy for you. He has a free website that identifies good companies being sold at a big discount...

www.magicformulainvesting.com

All you have to do is follow the step-by-step instructions in the book and go to the website to find the best investment opportunities. That's literally how simple it is.

Following this simple, common sense approach has worked extremely well over the years. Over the past 17 years, owning a portfolio of about 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8% per year. As the Little Book says, "Investing at that rate for 17 years, $11,000 would have turned into well over $1 million."

There are a couple of questions you should be asking yourself at this point:

1. If these are such good businesses, why would someone want to sell their shares to me at a discounted price?

2. Since this guy has put the Magic Formula in a book and even on a free website, everybody will use it. How is it going to continue to work after everybody and his dog is aware of it?

Good questions. In fact, they're so good that "The Little Book That Beats The Market" answers them very well.

First of all, why would shares of good companies be trading at bargain prices? The short answer to that is nobody knows why market participants behave irrationally at times, but the fact of the matter is they do. The way Greenblatt proves that to his class of very bright business school students is by having them look at stock tables in the paper. Take Abercrombie and Fitch, for example. The stock closed yesterday at $61 a share. But over the past year it has had a low of $43 a share and a high of $74 a share. So there's a $30 a share difference between the high and low for the year. That's a big range in a short period of time.

Why is there such a big difference in the high and low of the stock price for a big well known company like Abercrombie and Fitch during a single year? After all, the profitability of the company didn't change that much.

Again, nobody knows why people behave like they do -- willing to sell their shares at a low price one moment but demanding a high price the next. Greenblatt's short answer to that is "Maybe people go nuts a lot." And, I guess, that answer is as good as any. But it doesn't matter what the answer is. The fact that it happens is the reason that you can get really good deals on very profitable businesses.

And, eventually, the market always gets it right. A good business will always ultimately be priced at its true value. Or as the father of value investing, Ben Graham (Warren Buffet's mentor), famously put it: In the short run, the market is like a voting machine -- tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine -- assessing the substance of a company.

Why is the Magic Formula going to continue to work after everybody knows about it? That question is answered in the most important chapter in the entire book -- Chapter 8. The best thing about the Magic Formula, and the reason that it's going to keep working even after everybody knows about it, is that it doesn't always work. In fact, sometimes it doesn't work at all. There have even been times when the Magic Formula did worse than the overall market for as much as three years in a row. Isn't that wonderful?

It's wonderful because most people are not disciplined and patient enough to follow a winning formula that doesn't work for weeks, months, or even years at a time. Therefore, the Magic Formula will continue to work very well because very few people will have the discipline to stick with it. So there should be no worry about it losing its effectiveness. Most people won't use it simply because it doesn't work all the time. And that's wonderful news for the few who have the discipline and confidence to stick with it.

I'm not going to tell you that "The Little Book That Beats The Market" will make you rich, although I believe it can. I am going to tell you that if you'll pluck down twenty bucks or so for the Little Book, and if you'll spend the two hours it takes to read it, you'll be very glad you did.