Book Review: The Little Book That Beats the Market

Despite an audacious, even pretentious, title, Joel Greenblatt’s Little Book that Beats the Market is a worthwhile book. It seems absurd to pay so much for such a little book, but do not let that get in your way.

There are two keys to any successful investment strategy: having a winning strategy and sticking to that strategy. To stick with a strategy takes guts and determination. Beyond that, you must also be utterly convinced that your strategy will work. That is why I am a value investor and I pay no attention to many things that other investors fancy, such as new technology, paradigm shifts, and exciting products. Because so many investors before me have successfully used the basic strategy I use, I can rest assured that at worst I will do no better than the market as a whole. I fully expect that I will outperform the market by about 5% per year over the next 10 years.

Greenblatt’s book is useful first because it reaffirms much of what we already know and gives us data to increase our resolve. Second, his book can give us a good way to screen stocks.

The magic formula that Greenblatt mentions in his book is this: take the stocks with the combination of the best earnings yields (the inverse of P/E) and the best ROC (return on capital). Invest in each stock for a year and then repeat the procedure.

This is different from a true Graham-style value investor, who cares more about finding companies that are purely undervalued in terms of the P/E ratio or earnings yield. Overall, I agree with Greenblatt more than Graham, especially with pure value stocks seemingly overvalued now.

Now, one of the keys of Greenblatt’s magic formula is that for earnings yield he does not use just the inverse of P/E. He uses EBIT / Enterprise Value. For an explanation of why this is a good thing, see the forthcoming article, “Accruals & EBITDA,” which includes a great example I blatantly took from Greenblatt’s book.

The other key to the secret magic formula for immortality and enlightenment (or something like that), is ROC. No, not the bird. Not even receiver operating characteristics. ROC is Return on Capital. It is not to be confused with ROA (return on assets) or ROE (return on equity). It is harder to calculate than either ROE or ROA, but it is more precise and more useful.

All three terms measure the efficiency of a company’s use of capital. Each is calculated by taking net income and dividing by a different measure of capital. ROE uses the amount of stockholders equity; this is flawed because stockholder equity bears little relation to a company’s assets. ROA uses the total assets of a company; this is flawed because it includes non-earning assets such as goodwill.

ROC includes only earning assets; it uses EBIT as the measure of net income and net working capital plus net fixed assets as the measure of capital. It is thus a more true measure of how much money would need to be expended to achieve a certain increase in earnings. A ROC of 30% would indicate that for each dollar spent on new capital equipment, 30¢ of EBIT would be produced.

Why is ROC important? Any business, no matter how bad its ROC, can be a good deal if bought cheaply enough. However, if the ROC is 3%, it would be foolish to expand the business—it would make more sense to invest that money in bonds and earn 4.5% with no risk. Thus, the higher the ROC, the more profit will accrue in expanding the business. Investing in such great businesses is a way to achieve investing success.

The magic formula simply ranks companies on ROC and EBIT / EV and produces a list of the companies with the best average rank. While this is a very simple concept, it is a good one. I heartily recommend screening for stocks using this method. Greenblatt has even made it easy for us at his website (free registration required).

Buy the book. It is a good introduction to investing and thus makes a great gift.

Disclosure: This review was originally written two years ago and published elsewhere.