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That Magic Little Book

July 30, 2006
Charlie Tian

Charlie Tian

3 followers

When I first heard about Joel Greenblatt’s “The Little Book That Beats the Market”, I was skeptical. Investing has never been that simple. I have read most of value investing classics, from the bible “The Intelligent Investor”, to Peter Lynch’s “Beating the Street”, to Warren Buffett’s annual shareholder letters. Through the readings I have been converted from a technology speculator to a value investor. My investment returns have improved significantly, but they are still not as good as the numbers claimed in the “little book”.

I bought the book, anyway. But it was put on shelf. Until recently when I was going to a business trip, I took it with me. The flight was early and I was sleepy. I started the book, thought it would help me to sleep. But what happened was that I finished more than two-thirds of it in the 2-hour flight. The business meeting was exciting but tiring. During my trip back I finished it. Then I read the last three chapters and the Appendix again.

After I was back home and saw my 10-year-old son, Bob, I was reminded the first sentence of the Introduction, “This book was originally inspired by my desire to give each of my five children a gift...” I gave the book to Bob, and tried to convince him to read it. Being a Harry Potter only reader, it is hard to have him read anything else. Then I told him that this book talked about a gum business. He was immediately attracted by that because he was a loyal consumer of bubble gum, and he started to read.

Believe or not, after 30 minutes, Bob told me he was on page 70. The next day, he finished it. I asked him how he liked it. These are some of our conversations:

Charlie: How do you like Jason’s gum business?

Bob: I like it, it is great!

C: How does Jason make money?”

B: He buys gum for 25 cents a pack, with five pieces in each pack, and sells the gum for 25 cents a stick. After paying the purchase price, he can earn a dollar for every pack of gum he sells! That’s pretty amazing for a guy who’s in sixth grade.

C: Do you like Jumbo’s Just Broccoli? How does it compare with Jason’s Gum Shops?

B: Well, I don’t really like that business.

C: Why?

B: Because it costs $400,000.00 to build a new Jason’s Gum Shops or Just Broccoli store, but Jason’s Gum Shops could earn $200,000 a year. Joel Greenblatt calls that the return on capital, which is 50%. However, Just Broccoli only earns $10,000 a year, so its return on capital is only 2.5%. Therefore Jason has a better business. Of course I like the better business. Oh, dad, the book mentioned about the risk free 6% return, what is that?

C: That is if you buy US government bonds, your risk of losing money is almost zero, and on average you are guaranteed a 6% annual return. Any business should at least earn a return on capital higher than that. Otherwise they should just sell their business and buy the government bonds. Ok, if you wanted to buy a business between Jason’s Gum Shops Jumbo’s Just Broccoli, you would certainly buy Jason’s Gum Shops. Would you buy it at any price?

B: Yes!”

C: At any price?”

B: Well, at reasonable prices.”

C: Is it better if you can buy at lower than reasonable prices?”

B: Sure!”

C: But how do you know if the price is reasonable?”

B: Joel Greenblatt uses earning yield to measure the price. He did not mention how much is a reasonable price. The “magic formula” ranks stocks from 1 to 3,500, with 1 being the best. To determine a stocks ranking, you look at its return on capital and earnings yield. When you add these together and compare them with other stocks, it will determine the better stock. For example, a stock with an earnings yield in the 125 th rank and a return on capital in the 176 th rank would rank higher than a stock that is 1 st in return on capital but only 3,245 th on earning’s yield because 301 is obviously lower than 3,246. Therefore, the stock with a 301 total would rank higher than the stock with the total of 3,246. So, with only one at a high rank, your ranking would not be as high. A good stock would have to have high earnings yield and high return on capital.

C: Good! I have a question: among the “magic formula” top ranked companies, some are really good and successful, why they are sold for such a low price?

B: Well, the answer is, nobody really knows. Like the book mentions, the stock market is like a constant mood-changing man named Mr. Market. Every day, his mood is different. Sometimes, when he’s in a grumpy mood, he might name several great companies at very low prices. When this happens, you might want to buy some of these stocks. On other days, he might be so excited that he makes stock prices rocket off the wall at really high prices. When this happens, you usually would want to sell your stocks. Or on other days, you could just choose to do nothing. So, as said before, you have three choices you can make when owning shares of a stock: When stock prices are low, buy some shares of stock. When stock prices are high, sell some shares of stock. When the stocks prices are neutral, do nothing.

C: Great! I am glad you understand this. I have another question, is it possible that the “magic formula” is so popular that everyone starts to use it, and it does not work anymore?

B: Well, unlikely. You see, it takes time to allow the “magic formula” to work, and sometimes it takes even a couple of years. In the first year you will most likely make very little profit, or even lose some money. That’s why you also have to really believe it. Then you will continue waiting for its “magic” to work. But most people can’t wait that long. As Joel puts it, to have the magic work, you need to understand why it works.

C: If I understand why it works, do I still need it?

B: Maybe not. Wait… does this mean that the “magic formula” is totally useless? People who don’t understand it will give up someday, sooner or later; and people who understand it don’t need it? Will you buy stocks top-ranked by the “magic formula”?

C: Well, I don’t think I can buy a stock just because the “magic formula” ranks it high. I need to do more homework. I need to read the reports, compare the business with other businesses, especially its competitors. Also I need to find out whether the price is really “reasonable” or better “below reasonable”. But I still think the “magic formula” is useful, it can serve as an initial screener for my research.

B: That is what Joel Greenblatt is doing. He recommends investing in 25 stocks with the “magic formula”, but he himself invests in only 5-6 stocks.

……

As the conversation went, what I had in my mind was: “Thank you, Joel! You have given a gift not only to your children, but also mine.”

10 minutes later, my son, Bob, was showing me a book taken from my bookshelf. The cover of this book shows a guy at his 50s with completely grey hair. The title of the book was “One Up On Wall Street”. He asked me: “Dad, is this also an interesting book?”

About the author:

Charlie Tian
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.2/5 (10 votes)

Comments

vooch
Vooch - 7 years ago
Charlie,

Nice article.

- Vooch

kfh227
Kfh227 premium member - 7 years ago
Wow, now I don't have to buy the book :-) I might have to buy it just so when my two year old boy turns 10, I can have him read it. If I knew then what I know now .....

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