What would you say if I told you that an author had released a book claiming that he had discovered a two-step formula that would absolutely trounce the stock market?
Would you laugh? Probably. You might even say "It can't possibly be that easy!" And the thing is, normally, you'd be right. There are so many books and services selling the snake oil of easy stock market wealth that you'd be wise to ignore them. In fact, let's run down the checklist of reasons that you would want to avoid this particular book.
- A salacious title virtually guaranteeing market-beating returns? Check.
- Facile references to Warren Buffett? Check.
- An easy-to-follow formula? Check.
- A claim that these results are backtested? Check.
And that should be that. Except ... except that unlike the Wade Cooks of the world, the author happens to be an investor whose fund has grown at a compound rate of 40% over the last two decades. That's the equivalent of turning $1 into $800. Not even Warren Buffett has achieved that over any 20-year period (though Berkshire Hathaway has averaged a still-bodacious 22% over its history). Not only that, but this book is based on the same core values that the author has used to seek out stocks during his investing career.
So Joel Greenblatt's new book, The Little Book That Beats the Market, is better than your run-of-the-mill "get rich quick" entry. Were that the extent of its utility, I wouldn't be wasting your time. Instead, this is a book that should be read by anyone serious about investing. And the shocking thing is, unlike the hard-to-grasp intricacies of the Benjamin Graham value-investing classics, this is a quick, entertaining read.
Greenblatt's goal was to write a book that would describe to his young children what he does for a living. Basically, his investing methods are based upon two elements: pre-tax earnings yield (the percent of the stock's price that comprises current earnings) and return on capital. Shove every company above a certain size into the transmogrifier, and it generates a list ranking companies on the combination of those attributes. Investing in the top 30 companies on these lists each year has generated an average annual return of 30.8% over the last 17 years.
Of course, here is where you say exactly what I said when I first read the book. "But this is data-mining, right?" It's pretty easy to go back in time and try a bunch of various elements until you show one that offers awesome returns, including things like investing each year on April 22 in the top 77 stocks that don't have 'e' in their names. And you'd be right, except for two things. First, and foremost, these are the only two elements that Greenblatt tried. Second, the two data points used are imminently defensible as reasonable measurements for potential investments: How much do they make? And how much do they cost?
As Greenblatt notes in the book, one of the great things about the formula is that occasionally it doesn't work.
Oh, you want me to explain why that could possibly be good? Well, one of the most hallowed truths in investing is that something that works all of the time will immediately be rendered neutral by the market. A company cannot be priced at $1 per share while earning $17. Not for long. For those who might think that Greenblatt immediately renders his magic forumla useless by writing about it, take heart. In an age of attention spans measured in seconds rather than years, the formula's occasional failure means that many investors won't stick with it.
A look at Greenblatt's screen currently identifies some perhaps unknown companies like VaalcoEnergy
Bill recently conducted an interview with Joel Greenblatt, available exclusively to subscribers of The Motley Fool's small-cap newsletter, Motley Fool Hidden Gems . Come see what stocks Bill and Fool co-founder Tom Gardner unearth each month, plus gain access to our exclusive commentary, interviews, and award-winning community. A free trial is available here.
Bill Mann owns shares of Berkshire Hathaway. The Motley Fool has a disclosure policy