A couple weeks ago, a friend of mine lent me the book
The Little Book That Beats the Market
written by
Joel Greenblatt which I featured on RetireRichBlog.com.
Who wouldn’t want to learn the secrets of
40% annualized returns in which Joel has achieved since 1985.
In my opinion, this book is geared towards the novice investor just starting out. As Joel points out, he originally intended to write this book for his kids. So it’s hard to believe fund managers would read such a simplistic book but the accolades say:
“Simply perfect. One of the most important investment books of the last 50 years!” – Michael F. Price
“A landmark book – a stunningly simple and low-risk way to significantly beat the market!” –Michael Steinhardt, the Dean of Wall Street hedge fund managers
In a nutshell his “magic formula” stock investing method is suppose to replace Ben Graham’s formula of finding stocks below book value (hard to find these days) by focusing on 2 things: The earnings yield and return on capital.
The earnings yield is your initial rate of return when you buy a stock. Instead of price to earnings ratio, it’s the opposite. Earnings divided by price.
I.e. ABC Stock Price is $10.00, earnings per share is $2.00
E/P = 2/10 = 20% return.
If you buy ABC stock, you will get a 20% return versus a 5% risk-free return treasury bond. The only difference is that 20% is not given to you but reinvested in ABC business. Your future return is based on how well future earnings will be and earnings rise, that would be reflected in a higher stock price.
Joel Greenblatt’s return on capital is similar to return on equity. The better ROE of the company, the better that 20% return is invested for you to have increased earnings per share.
For advanced investors, Joel Greenblatt’s actually earnings yield calculation is EBIT/Enterprise Value, and return on capital is EBIT/(Net Working Capital + Net Fixed Assets). You’ll have to read his book for his explanation.
Greenblatt ranks stocks based on using the earnings yield and return on capital. You can login to his website, magicformulainvesting.com or you can use any type of stock screening and use the criteria, return on assets (ROA) at 25%, and finding the lowest p/e ratios (in place of earnings yield).
The Little Book That Beats the Market is a quick read (I’d say two hours) and I would recommend it to anyone especially those starting out in the stock investing world. Although this book is very simplistic, it is the results I am after and this book has taught me to look at the initial rate of return more closely.
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