To be completely honest, the title is what actually attracted me. Apart from being catchy, the title “The Little Book That Beats The Market “ induced a sense of curiosity. I was beating myself as to how a little book can beat the likes of skilled Asset Managers, scores of analysts sitting in glass buildings. The book was a humorous yet excellent read. The core concepts are wrapped inside layers and layers of hilarious but stuffy conversations.
Anyway, below are my takeaways from the book. I’m definitely looking forward to implementing the “magic formula”. The magic formula is a tried and tested method to earn market-beating returns,” According to what the book says”. I am planning to backtest the strategy myself in the coming few weeks. I think this “magic formula” takes away a lot of effort “Fundamental investors” put in to evaluate stocks.
Fundamental Investors, rely on the fundamentals of the business. From my personal experience, it takes about 16-40 hours to analyze a company. Shortlisting a particular company is another time taking activity in itself.
For that reason, I think this book will definitely appeal to the lazy investors in us. One who wants to ride the wave on the back of a time-tested formula.
A DISCLAIMER. Well, as you will read below, I add a lot of my own perspective to the views mentioned in the book. Feel free to contest them in the comments. And this goes without saying, this summary is is a collection of my takeaways. My perceptions and viewpoints greatly affect how I understand what Mr. Greenblatt suggested. So, my sincere suggestion is to take this as a reference but not a replacement for the book.
Without any further delay, let’s jump into what this little book has to say about beating the markets.
Why do you want to invest in the stock market?
I think this is the single most important question one needs to ask themself. Though Joel Greenblatt doesn’t ask this directly, he answers the question.
A quick look at the avenues of investment available to “A Normal Individual.”
- Keep the money in Savings Account
- FD or RD
- All sorts of Company and Government Bonds
- Mutual Funds
- Index Funds
- Individual Stocks
The rate of return for the above options varies from as low as 2.5% to a whopping 30%(approx). Likewise, the risk level of the instruments also varies from “very safe” to “Ultra High Risk”.
Money in your savings account is actually losing value year on year. As inflation rate climbs, you should always look for instruments with a higher rate of return. Else you’ll simply lose money because of inflation. So remove that as an avenue of investment.
The next best investment is the FD or RD, which typically gives a return of 5% -7.5 % in India.
So, the rate of returns without having to take any risk is 6% (Just finding a middle ground of 5%-7.5%). Any other avenue you choose should, if it has a greater than zero risk, give you a return higher than 6%. That’s investing 101.
So, if you want to grow your money at a significant rate, for whatever reasons, then equity investments (Index Funds, Mutual Funds, and Individual Stocks) are the way to go.
Why Individual Stocks?
I am not sure how familiar are you with the cost structures of the mutual funds. But I am gonna digress here for a bit and explain that.
Why Not Mutual Funds?
So, Mutual Funds are nothing but a group of stocks. These stocks are picked by professional money managers aka Asset Managers. They are also supported by qualified analysts in making those decisions. Because they are doing the hard work, they usually take a cut from the returns. It is called as “Expense Ratio” in India. It typically ranges from 0.5 % – 2% or so if I remember correctly. You may laugh it off saying 0.5% is so tiny, but in the long run this 0.5% snowballs into a huge sum. For the reason of expense ratio, people like myself are slowly losing interest in Mutual Funds.
Why Not Index Funds?
Moving on to Index funds, this is again a group of stocks. But the stocks are picked according to the index they track. The index is nothing but a group of stocks put together that have some “commonality/criteria”. The grouping is done by Exchanges. And all the fund managers of Index funds need to do is to figure out the composition of the index. The composition is publicly available on the websites of the exchanges.
Because the information is publicly available and it takes lesser effort for the fund manager to manage an index fund, the expense ratios are lower. Hence Index funds are much more attractive compared to Mutual funds or actively managed funds.
But is it possible to go lower than the expense ratio of the Index funds?
Turns out, you can. That is by directly investing in the individual stocks. Of course, even the gains from Individual stocks are subjected to long term capital gains tax and short term capital gains taxes. But it appears to be lower than the expense ratio of index funds.
Individual Stocks And The Magic Formula
At this point, I hope you’re convinced as to why it makes sense to invest in Individual stocks. However, there is one problem. Evaluating a company’s actual price and deciding if you want to invest or not, is not everyone’s cup of coffee. That’s where the Magic Formula steps into the den.
Magic Formula doesn’t care about a lot of the things that a fundamental investor or value investor would do. It just sticks to two factors and asks you to blindly pick the ones it throws at you. Let’s take a look at the steps of the formula, shall we?
- Make a list of the largest companies that are currently trading on exchanges. Let’s say you picked up 100 different stocks
- Rank them based on the Higher Return On Capital, 1 through 100.
- Then, also rank them based on the Higher Earnings Yield, 1 through 100.
- Sum up both the ranks and pick the top 20-30 stocks. However, if you understand the underlying businesses, then narrow it down to 8-10 best picks from the above list.
P.S: I’m skipping the part explaining what Return on Capital and Earnings Yield means. It needs a deeper understanding of how businesses run and I will probably write another blog post explaining those things.
“Well, that’s it? That simple?” you may ask.
Well, I know it is unbelievable. But the book presents ample evidence of it working. But we can always backtest and check authenticity. I’m gonna do that next for sure. On a concluding note, “The Little Book That Beats The Market” suggests you take a few precautions before using the magic formula.
Precautions For Using The Magic Formula
I can personally attest to the precautions mentioned below. A lot of them are consistent with the other Investing books I’ve read. Below is what Mr. Greenblatt says:
- You should forget about the investments for 2-3 years.
- There will be times when the formula doesn’t seem to be working. But Mr. Greenblatt suggests you stick to the formula and sail through it.
- Emphasize on owning 20-30 stocks based on the formula.
You can purchase the book here on amazon. When you buy the book from the link, I’ll get a small cut. It will help continue run this website and put out content you love.
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Check out my Personal Finance series that talks about frameworks to reduce expenses and increase income. Also, check out my thoughts on Dhandho Investing here.
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