Bulkowski’s Book Review: The Little Book That Beats the Market

Written by and copyright © 2005-2018 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners.

The Little Book That Beats the Market, by Joel Greenblatt

The Little Book That Beats the Market, by Joel Greenblatt

For six months now, I have been wondering how to achieve the kinds of returns I made 20 years ago. This book might have the answer. The hardback explores one facet of value investing, what the author calls the magic formula. If you buy a portfolio of 20-30 stocks based on a high earnings yield and a high return of capital, hold them for a year and reshuffle, you will beat the market over time with less risk.

When I first started reading the book, I rolled my eyes at the simplicity of the presentation, but did not find myself yawning. His words were engaging and lively while intentionally presenting the information in an easy-to-understand manner. Knowing that the author has "9 years of teaching at an Ivy League business school" and is the founder and managing partner of Gotham Capital certainly helped. In other words, he intentionally wrote the book so that "even my kids could understand." He succeeded.

Greenblatt focuses on the magic formula, that of ranking companies by their earnings yield and by return on capital. By ranking a company on each factor separately, summing the results, and then buying the stock of companies that rank near the top of the list, you can beat the market while lowering risk.

On page 56 he compares the results of approximately 30 of the highest-ranked stocks selected using the magic formula with the S&P 500. The magic set returned 30.8% from 1988 to 2004 while the S&P 500 averaged 12.4%. The S&P beat the magic formula only in 1995, 1996, and 1998, and the magic group were profitable in all years except one (2002 when they lost 4% compared to a loss of 22% for the S&P). In other words, the stocks did well in both bull and bear markets.

Greenblatt admits that small cap companies do better than the large caps so he provides additional tests to show that large caps also outperform the general market using the magic formula (page 61: 22.9% return for the magic group compared to 12.4% for the S&P 500). In this case, though, the S&P beats the magic group 5 years out of the 17 studied and the magic group has two losing years, 1990 (down 6%) and 2002 (down 25.3%).

The Magic Formula

Greenblatt spells out the details of the magic formula beginning on page 138, but the concept of the formula is simple. Select companies with the highest earnings yield and highest return on capital. How high is high, and what does he mean by earnings yield and return on capital? Before I define them, he says you can go to his website and get the results of his magic formula: magicformulainvesting.com. You select the minimum market cap for a company (he used 50 million in the study) and then you have to register to get the results. I stopped right there because I do not want to be added to someone's %^@* spam list. You might feel otherwise.

He also says that you can find similar information, either for free or not, by using the screening packages at businessweek.com, aaii.com, moneycentral.msn.com, powerinvestor.com, and smartmoney.com. I did not check these sites.

Earnings Yield

Early in the book (page 40), Greenblatt defines earnings yield as the annual earnings per share divided by the share price. Near the end of the book (page 141), he refines it as EBIT/Enterprise value. That's pre-tax operating earnings (EBIT: earnings before interest expense and taxes) divided by the market value of equity (number of shares outstanding times share price) including preferred stock plus net interest-bearing debt. He discusses reasons why earnings per share and share price are inferior to the more complicated formula.

Return on Capital

This is a measure of how well a company does when it invests its own money. From page 101 he says, "For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings." He uses trailing (last year's) earnings.

In the appendix, he gets more specific and says that return on capital is EBIT/(Net working capital plus net fixed assets). EBIT is pre-tax operating earnings compared to tangible capital employed. He says that "This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons," which he lists and I won't go into. You'll just have to read the book for additional details.

-- Thomas Bulkowski

Written by and copyright © 2005-2018 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners. Oprah Winfrey virus: Your 200MB hard drive suddenly shrinks to 80MB, and then slowly expands back to 200MB.