THE PE INVESTOR

The Little Book That Beats The Market, by Joel Greenblatt

Joel Greenblatt (born in 1957) is an American investor, academic, and writer. He is a Managing Partner and co-CIO of Gotham Asset Management, a successor of Gotham Capital which he co-founded in 1985. He teaches value and special situations investing at Columbia Business School.

Below are the key insights from The Little Book That Beats The Market:

1. Buying a share in a business means purchasing a portion of that business, and being entitled to a portion of its future earnings.
2. Figuring out what a business is worth involves estimating how much it will earn in the future.
3. The earnings should give you more money than you receive by placing the same amount in a risk-free 10-year government bond. Use 6% as a minimum annual return even if government bond rates fall below.
4. Over the short term, Mr Market acts like a wildly emotional partner who can buy stocks at depressed or inflated prices. As a result, stock prices move around wildly. This does not mean that the value of the underlycompanies has changed very much.
5. Over the long term, Mr Market gets it right and prices stocks based on their value.
6. Buying shares at a large discount to value will provide you with a margin of safety. One way to do it is to purchase a business that earns more relative to the price paid, i.e., a high earnings yield.
7. Benjamin Graham devised a formula to find such bargain issues: he bought groups of 20-30 companies whose stock prices were so low that the purchase price was lower than liquidation proceeds in a fire sale.
8. Unfortunately, few companies today meet the strict requirements outlined by Graham.
9. Buying a good business is better than buying a bad business. One way to do it is to buy a business that can invest its own money at high rates of return, i.e., a high return on capital. Companies that achieve a high return on capital (1) are special, (2) may have the opportunity to invest their profits at high rates thus contributing to high earnings growth, and (3) are likely to have a special advantage.
10. Greenblatt devised a formula to find good companies at bargain prices:
    • Start with a list of the largest 3,500 stocks trading in the US.
    • Eliminate utilities, financial stocks, foreign companies, stocks with very low P/E ratios (indicating unusual data) and stocks who have just announced their results (to avoid untimely data).
    • Assign a rank from 1 to 3,500 based on their return on capital, defined as EBIT/(Net Working Capital + Net Tangible Fixed Assets).
    • Assign a rank from 1 to 3,500 based on their earnings yield, defined as EBIT/ Enterprise Value, with EV = market value of equity (including preferred equity) + net interest-bearing debt.
    • Sort the stocks based on their combined ranking.
    • Buy 5-7 top-ranked companies. Invest only 20-33% of the money you intend to invest during the first year.
    • Repeat this every 2-3 months until you have invested all of the money you have chosen to allocate.
    • After 9-10 months, this should result in a portfolio of 20-30 stocks.
    • Sell each stock after 1 year.
    • Repeat the process every year (for a minimum of 3-5 years).
    • The magic formula eliminates companies earning poor or ordinary returns on capital.
11. • The magic formula appears to work for companies both small (>$50m market cap) and large (>$1bn market cap), and over the long term, but may not work for several years in a row.
12. • The magic formula can be improved by:
      • Using estimates of earnings in a normal year instead of last year’s earnings.
      • Selecting stocks from the top 50-100 stocks as ranked by the magic formula.