“Believe it can be done. When you believe something can be done, really believe, your mind will find the ways to do it. Believing a solution paves the way to solution.” – David J. Schwartz
In “The Little Book That Beats the Market”, Joel Greenblatt, Founder and Managing Partner at Gotham Capital (average annualized returns of 40% for over 20 years), sets out the basic principles for successful stock market investing.
In his book, Greenblatt provides a “magic formula” that makes buying good companies at bargain prices process driven. It takes a bunch of stocks (Russell 3000) and ranks them on quality; takes the same bunch and ranks them on value. Add the two ranks and buy the stocks with the highest summed ranks. Hold them for a year or preferably longer.
The formula is based on two very solid pillars of value investing: Invest in companies with high returns, and make sure they’re selling at a large discount (margin of safety).
For his quality factor, Greenblatt chose return on capital, defined as EBIT (earnings before interest and taxes) divided by the sum of working capital and fixed assets. For his value factor, Greenblatt chose EBIT divided by enterprise value.
“If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.”
“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
“In short, 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 earn above-average profits.”
“Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period. In effect, the stock market acts very much like a crazy guy named Mr. Market.”
“Although over the short term, Mr. Market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to Mr. Market.”
“After more than 25 years of investing professionally and after 9 years of teaching at an Ivy League business school, I am convinced of at least two things: 1. If you really want to “beat the market,” most professionals and academics can’t help you, and 2. That leaves only one real alternative: You must do it yourself.”
― Joel Greenblatt, The Little Book That Beats the Market
“Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices. Over the long run, it’s a completely different story: Mr. Market gets it right.”
“Although over the short term Mr. Market may price stocks based on emotion, over the long term Mr. Market prices stocks based on their value.”
Greenblatt’s three basic principles:
- Buy good companies;
- Buy them at bargain prices;
- Use ranking to pick stocks.
Financial commentator Gary Shilling likes to say, “The stock market can remain irrational a lot longer than you can remain solvent.”
T,hus, when looking for bargain prices, you need to look at a lot more things than earnings yield, and when looking for good businesses, you need to look at a lot more things than high return on capital.
You can’t judge a business as good or bad without looking at its stability, its growth prospects, and the quality of its earnings; and you can’t judge a business as a bargain without looking at a variety of valuation metrics.
References:
- https://www.goodreads.com/work/quotes/73414-the-little-book-that-beats-the-market
- https://www.fool.com/investing/general/2007/03/23/foolish-book-review-the-little-book-that-beats-the.aspx
- https://seekingalpha.com/article/4374333-how-market-beat-little-book-beats-market-stock-pickers-guide-to-joel-greenblatts-magic