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“The Little Book That Beats The Market” by Joel Greenblatt is without apparent effort the investment book of the year. In fact, it’s the best investment book that I’ve read in a great deal of years. In 130 pages, which may effortlessly be read in a couple of hours, Greenblatt gives the reader a stunningly simple, crystal clear formula for beating (make that trouncing) the market that anybody — and I mean any individual — may follow. Joel Greenblatt is a professor of securities analysis at Columbia University as well as the founder and managing collaborator of Gotham Capital, a hedge fund with intermediate annualized returns of 40% for over twenty years. When it comes to great investors, he’s amidst the best of the best. Greenblatt has an agreeably diverting and humorous writing style that makes each page fun to read. And, like most outstanding teachers, he has a knack of explaining sophisticated financial conceptions in a mutual sense, down-to-earth way that a sixth grader could effortlessly grasp and enjoy. In fact, the book begins with Greenblatt using Jason, an 11-year old boy with a chewing gum business as an example (he buys gum for 25 cents a pack and sells each stick at school for 25 cents for a $1 a pack profit). He asks his young son, “Ben, if Jason offered to trade you half of his business, how much would you pay?” As Ben thinks in regards to how much Jason’s business might earn for the duration of his years in school, Greenblatt explains that assessing the value of businesses so he may buy them a bargain price is what he does for a living. “The Little Book That Beats The Market” is in regards to how to find good businesses to buy at bargain prices. By buying shares of companies for much less than what they’re worth you, the investor, will have a big “margin of safety” that will lead to safe and systematically profitable investments. So the plan is to buy a part interest (shares) of good businesses at bargain prices. That’s how to make a lot of money. How do you find these businesses? Are you going to have to learn how to pour over remainder sheets and income affirmations and do sophisticated financial analysis? Not at all. And that’s the beauty of the Little Book. Greenblatt gives you a simple “Magic Formula” that you may use to find outstanding investment opportunities. A good business is one that may invest it is own cash at a high rate of return. In other words, a good business is one that may earn a high return on capital. There is more than one way to determine return on capital. The formula that Greenblatt uses is operating net income as a part of net working capital and net fixed assets. The higher the return on capital the better the business. So now you recognise how recognize a good business. But how do you recognise when a good business is being sold at a bargain price so you may make a lot of money? Greenblatt uses earnings yield to determine that. As with return on capital, there are respective ways to determine net profit yield. Greenblatt uses operating net income as a portion of enterprise value (market value of equity plus net interest-bearing debt). The higher the net profit yield the better the bargain. The only Magic Formula you need to discover good companies retail at bargain prices is to find the ones with the best combining of a high return on capital and a high net profit yield. However, that still requires a sure amount of actual work (yikes!). And it requires a familiarity with terms like “operating profit,” “working capital,” “fixed assets,” “enterprise value” and the like. So Greenblatt has even made that part easy for you. He has a free web site (magicformulainvesting.com) that identifies good companies being sold at a huge discount. All you have to do is follow the step-by-step instructions in the book and go to the internet site to find the best investment opportunities. That’s in a literal sense how simple it is. Following this simple, mutual sense approach has worked exceedingly well over the years. Over the past 17 years, owning a portfolio of in regards to 30 stocks that had the best combining of a high return on capital and a high net profit yield would have returned approximately 30.8% per year. As the Little Book says, “Investing at that rate for 17 years, $11,000 would have turned into well over $1 million.” There are a couple of questions you ought to be asking yourself at this point: 1. If these are such good businesses, why would somebody want to trade their shares to me at a discounted price? 2. Since this guy has put the Magic Formula in a book and even on a free website, everyone will use it. How is it going to carry on to work after everyone and his dog is conscious of it? Good questions. In fact, they’re so good that “The Little Book That Beats The Market” answers them very well. First of all, why would shares of good companies be retail at bargain prices? The short answer to that is not anyone knows why market players behave irrationally at times, but the fact of the matter is they do. The way Greenblatt proves that to his class of very bright business school students is by having them look at stock tables in the paper. Take Abercrombie and Fitch, for example. The stock closed yesterday at $61 a share. But over the past year it has had a low of $43 a percentage and a high of $74 a share. So there’s a $30 a percentage divergence among the high and low for the year. That’s a huge range in a short amount of time of time. Why is there such a big divergence in the high and low of the stock price for a huge well known company like Abercrombie and Fitch for the duration of a single year? After all, the profitability of the company didn’t modify that much. Again, not a single soul knows why people behave like they do — more than willing to trade their shares at a low price one moment but demanding a high price the next. Greenblatt’s short answer to that is “Maybe people go nuts a lot.” And, I guess, that answer is as good as any. But it doesn’t matter what the answer is. The fact that it happens is the reason that you may get in truth good deals on very profitable businesses. And, eventually, the market always gets it right. A good business will always at last be priced at it is true value. Or as the father of value investing, Ben Graham (Warren Buffet’s mentor), famously put it: In the short run, the market is like a voting machine — tallying up which firms are standard and unpopular. But in the long run, the market is like a weighing machine — assessing the substance of a company. Why is the Magic Formula going to proceed to work after everyone knows in regards to it? That question is answered in the most important chapter in the entire book — Chapter 8. The best thing with regards to the Magic Formula, and the reason that it’s going to keep working even after every one knows with regards to it, is that it doesn’t always work. In fact, at times it doesn’t work at all. There have even been times when the Magic Formula did worse than the overall market for as much as three years in a row. Isn’t that wonderful? It’s terrifi because most humans are not disciplined and patient sufficient to follow a winning formula that doesn’t work for weeks, months, or even years at a time. Therefore, the Magic Formula will carry on to work very well because very few persons will have the discipline to stick with it. So there will have to be no worry in regards to it losing it is effectiveness. Most persons won’t use it merely because it doesn’t work all the time. And that’s terrifi news for the few who have the discipline and selfconfidence to stick with it. I’m not going to tell you that “The Little Book That Beats The Market” will make you rich, altho I believe it can. I am going to tell you that if you’ll pluck down twenty bucks or so for the Little Book, and if you’ll spend the two hours it takes to read it, you’ll be very glad you did. (c) Larry Holmes
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