The Little Book That Still Beats the Market — Book Review & Discussion
The Little Book That Still Beats the Market by Joel Greenblatt is a concise guide for building a market-beating, stock-picked investment portfolio. Greenblatt, an influential investment professional at Gotham Capital and Columbia Business School professor, distills the principles of value investing and provides actionable steps relevant for beginners and masters alike. The book offers sophisticated advice in an easily digestible, accessible manner.
The Value Investing Philosophy
Greenblatt bases his investment strategy upon the value investing philosophy, which was pioneered by industry legends David Dodd and Benjamin Graham, and most famously epitomized by Warren Buffet. Value investing is a strategy that looks to purchase good businesses at bargain prices. Good businesses are those which are able to generate a high return on capital invested. A bargain price is one where the market value is less than the intrinsic value. The difference between the purchase price and actual value is what is known as the margin of safety. Key to the value investing philosophy, this provides a degree of comfort, should business returns turn out to be less than expected, and provide extra returns should things turn out well.
Throughout the years, many practitioners have had their own methods for applying the value investing philosophy. For example, Benjamin Graham, famously emphasized the margin of safety, even if the business was mediocre. So long as the value of the assets, when liquidated, proved to be more than the price, Graham would invest. This makes sense, considering Graham’s context coming out of the Great Depression. Buffet, on the other hand, has written many times in his annual shareholder letters about how he has learned the hard way the importance of investing in a good business. Buffet has found that a lackluster or mediocre businesses, even if offered at a bargain price, are not a worthwhile investment. Most notably, Buffet had his own run with a US textile business — which although offered at a great price at the time, proved to be increasingly difficult to operate within the US in face of global competition.
Greenblatt’s philosophy, most broadly, is more in line with Buffet’s than Graham’s. Indeed, Greenblatt is looking to purchase great businesses (as measured by a return on invested capital) at great prices (as measured by the earnings yield). The key difference in his strategy, say to Buffet’s, is that Greenblatt suggests a fair degree of diversification and advocates for yearly churn. Buffet, on the other hand, advocates for investing in relatively few companies, which would each be understood deeply. Furthermore, Buffet was generally a buy-and-hold investor — unconcerned with trends or price changes between years and refusing to sell winners in most cases.
Greenblatt’s Magic Formula
In the book, Greenblatt prescribes his own magic formula. He asserts that over time his formula can significantly outperform the market when indexed by the S&P 500. As mentioned, the key tenet of value investing is buying into good businesses at bargain prices. Therefore, the key to understanding and value investing strategy is digging into the framing of these issues: how does one evaluate if a business is “good” and how does one know if the price offered is at a “bargain”?
For Greenblatt, a good business is one that has a high return on capital, per the following ratio…
EBIT/(Net Working Capital + Net Fixed Assets)
EBIT is essentially Operating Earnings, which allows a business’s profits to be considered, without the distortions that arise when using net profit from variable tax rates and leverage ratios. Net Working Capital + Net Fixed Assets is Tangible Capital Employed, which is a metric that assesses how much capital is actually needed to run the business operations. Net Working Capital is the difference between current assets and liabilities; Net Fixed Assets factor in the asset value against the cost of depreciation over time. In sum, this formula is used to understand how much is earned relative to the cost of running the business.
A bargain price is one where the market price is at a low multiple relative to annual earnings. The ratio he uses…
Enterprise Value is used over Market Capitalization (aggregate value of outstanding shares), because it also factors in net debt, which may be used to help generate earnings. Similarly, EBIT is used to place firms with different leverage ratios and tax rates on equal footing when comparing earnings yield.
Once these formulas are crunched for a list of stocks within a given market capitalization, the companies are then afforded rankings commensurate with each of their scores. Two ranked lists emerge: one ranking companies with highest return on capital, another ranking companies with highest earnings yield. To be successful, the investor should select a basket of around 20–30 of these stocks, aiming to maximize across both metrics to the fullest extent possible.
Greenblatt advocates for a simple strategy, which involves recalculating these numbers on an annual basis, and churning the investment account in accordance with the updated scores. For tax reasons, the investor should sell losers just before a year elapses, to maximize tax loss harvesting, and winners just after a year, to afford themselves a lower, long-term capital gains tax rate.
Per the calculations laid out in the book, from the backtested 17-yr period between 1988 and 2004, the average return was 33%. This is considerably more than the S&P 500 average annualized return during the same period, which sits at 14%.
My Take On This Strategy
While I don’t doubt that the results Greenblatt achieved with his magic formula were impressive, and it goes without saying his track record of market-beating returns is outstanding, I think that any investor should read this book with a grain of salt. For one, from a little bit of research I have done, it seems that this strategy has not performed as well in recent years as it has historically. This may be due to a number of reasons, perhaps connected to the outset of the GFC.
Though some investors are able to achieve outsized returns for a number of years consistently, there is a difference between sustaining 33% annualized average returns over a 17-year period and doing it over a 50-year period. The latter feat being, obviously, much more difficult to achieve. We might say, as a comparison, would it be easier to run an X-paced mile in a half marathon, or in a marathon?
It is more difficult to achieve substantially outsized returns over a longer period because the world develops and markets change. Strategies that may work during some periods may fall out of favor later — Warren Buffet, for example, iterated upon Benjamin Graham’s strategies. Moreover, if there is a simple strategy that can allow individuals to achieve significantly above-market returns in the future, assuming they can stomach added volatility and be patient, then everyone would do it. And if everyone was doing it, then it would be impossible for these returns to be anything but average. Even Greenblatt acknowledges this very principle in the book.
There is certainly a lot more I do not know than I do know — and perhaps I am in part naive to critique Greenblatt at this stage of my career — but I think this book presents as a little too good to be true. And I think the average retail investor would be foolish to follow the advice laid out in the book, word for word.
Where the book does succeed is that it lays a great foundation for value investing, and may lay out a basic strategy that can serve as the foundation of a revised investing strategy, or as a component of a larger one. Even if this strategy is far from as magical as the author professes, it is still sound and valuable.
I would recommend taking a crack at this book. It’s a quick read, accessible, and enjoyable while being particularly accessible to beginners. But, if part of you ends up thinking it’s perhaps too good to be true — well, it probably is!