Cliff Notes on The Little Book That Beats The Market
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- Here is my cliff notes version of "The Little Book That Beats The Market" by Joel Greenblatt:
- To pre-face, this book was written in 2006. The intro chapters of the book include a made up example of a kid's gum business in school. The biggest take-away from this example is that you should invest in a business that you believe in (or sometimes this is the person behind the operation; how savvy of a business person they are). In order to make money we give this person an upfront amount of money now with the expectation to acquire a Return On Investment in the future -- long-term 3+ years in order to hopefully reap the rewards. Joel does mention that two ways the ROI could not be in our favor down the road are if more competition opens, and if profits do not reach certain expectations. On the flipside, the positives to these issues are brand loyalty and profits could exceed certain expectations.
- Joel then goes on to mention that if 10-year U.S. government bond rates are at least 6% then invest in that because what he teaches in the book's goal is to exceed the ROI of that in a much shorter amount of time (spoilers: unlikely for U.S. government bond to be at 6%.. but the risk is essentially 0% with a U.S. government bond). He also mentions you can buy bonds sold by other companies or groups; they promise higher interest rates than 6% but the risk of losing your money is there.
- So another thing we can do with our money is invest in that business I was mentioning in my first paragraph. Here are three things you need to know when determining if you should invest in a company or not:
- 1) Buying a share in a business means you are purchasing a portion (or percentage interest) of that business. You are then entitled to a portion of that business's future earnings.
- 2) Figuring out what a business is worth involves estimating (aka guessing) how much the business will earn in the future.
- 3) The earnings from your share of the profits must give you more money than you would receive by placing that same amount of money in a risk-free 10-year U.S. government bond.
- Next Joel talks about big named companies (GE, Abercrombie & Fitch, etc.) and how within a year their share prices could jump $40-ish or sink $40-ish, for example, and there is no logical reason for why this occurs, per se. Some illogical reasons why this can happen are due to people becoming depressed and not wanting to buy stuff.. or the polar opposite some people get excited sometimes and are willing to pay a lot.. lol. Essentially it boils down to sell high and buy low; let us say that GE is selling for $37 on a given day. Your move is based on what you think; if you think GE is a $50 share then you would feel inclined to buy that day and sell if/when it hits your perceived price.. If you think GE is a $15 share you'd feel inclined to not buy until the price drops... or you can simply do nothing. Excerpt: Graham referred to this practice of buying shares of a company only when they trade at a large discount to true value as investing with a margin of safety...Even if you originally estimated fair value to be $70, and it turned out the $60 or even $50 was closer to the true value for each share, a purchase price of $37 would leave enough margin for you to still make money on your original investment.
- Excerpt from the book that puts what I was saying about the company I mentioned prior into better perspective of what I am mentioning in the above message: By looking at the income statement that Jason had provided us, it turned out that Jason's chain of 10 gum shops had earned a total of $1.2 million last year--pretty impressive. Since Jason had divided his business into 1 million equal shares, we had concluded that each share was therefore entitled to $1.20 in earnings ($1,200,000 divided by 1,000,000 shares). At Jason's asking price of $12 for each share, that meant that based on last year's earnings, Jason's Gum Shops would have given us a 10 percent return for each $12 share purchased ($1.20 divided by $12 = 10 percent). That 10 percent return, calculated by dividing the earnings per share for the year by the share price, is known as earnings yield.
- The two requirements to successful share purchasing: stick to buying good companies (ones that have a high return on capital) and buy those companies only at bargain prices (at prices that give you a high earnings yield).
- Buying the stock with a high earnings yield trumps the option of buying the stock with a low earnings yield, if given the choice; same can be said about return on capital.
- Joel proceeds to say this: Over the last 17 years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year. Investing at that rate of 17 years, $11,000 would have turned into well over $1 million. During those same 17 years, the overall market averaged a return of about 12.3 percent per year. At that rate, $11,000 would still have turned into $79,000.
- On to the formula:
- The formula starts with a list of the largest 3,500 U.S. companies available for trading on one of the major U.S. stock exchanges. It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital would receive a rank of 3,500. Next the formula follows the same procedure but the time the ranking is done using earnings yield. The company with the highest earnings yield receives a rank of 1, and the company with the lowest earnings yield receives a rank of 3,500. Finally, the formula combines the rankings. The formula looks for the companies that have the best combination of those two factors. So, a company that ranked 232nd best in return on capital and 153rd highest in earnings yield would receive a combined ranking of 385. A company that ranked 1st in return on capital but only 1,150th best in earnings yield would receive a combined ranking of 1,151.
- In this system, the company that has the 232nd best return on capital could outrank the company that ranked 1st in return on capital. Why? Because we could purchase the company that had the 232nd best return on capital for a price low enough to give us a very high earnings yield (153rd cheapest out of 3,500 based on earnings yield). Note: this 17 year period I mentioned is 1988 - 2004.
- Joel goes on to talk about how the magic formula doesn't just work for only 30 stocks. The magic formula appears to work in order. The best-ranked stocks perform the best and as the ranking drops, so do the returns. Group 1 beats Group 2, Group 2 beats Group 3, Group 3 beats Group 4, and so on straight down the lane. Also, the magic formula doesn't work all the time.. this is a long term strategy so there is a chance within 5 months to 1 year you will dip into the negative, but if you are holding for 3-5 years, I supposed ideally 10+ years, you will see these numbers happen. Important excerpt: For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.
- Three important excerpts from the next chapter (9) are: The formula is systematically helping us find above-average companies that we can buy at below-average prices. We are looking for businesses that can achieve the highest percent annual returns. Lastly, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to each above-average profits. For example, Coke is a brand that has made a timeless name for itself and people are more inclined to drink Coca-Cola from Coke rather than an off brand cola.
- If using the magic formula to choose stocks to buy is not your thing then this is what you should be doing:
- The magic formula uses last year's earnings. We should be plugging in estimates for earnings in a normal year. Excerpt from book: Of course, last year's earnings could be representative of a normal year, but last year may not have been typical for a number of reasons. Earnings could have been higher than normal due to extraordinary favorable conditions that may not be repeated in most years. Alternatively, there may have been a temporary problem with the company's operations, and earnings may have been lower than in a normal year. Plugging in estimates for next year's earnings to our formula may suffer from the same problem. Next year may not be typical. So one solution might be to look ahead even further to our estimates of what earnings will be three of four years from now in a normal or average environment. Short-term issues that may have affected last year's earnings or that may affect earnings over the next year or two could then largely be eliminated from our thinking. In this ideal world, we would then be able to take our estimates of normal earnings and calculate earnings yield and return on capital. Using the principles of the magic formula, we could look for companies that had both a high earnings yield and a high return on capital based on normal earnings. Of course, we would also need to assess how confident we were in our estimates and make a judgement on whether those earnings were likely to grow in the future. We could then compare the earnings yield based on normal earnings to a risk-free 6 percent government bond and to our other investment opportunities.
- In chapter 12, Joel mentions that mutual, hedge, and index funds are other ways of investing. The chapter after that Joel explains IRAs and that when you earn a large sum of cash from the magic formula you should put some towards schools for the sake of charity.
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