The Hindu Business Line : Magic formula to make money

For the market-mangled, there seems to be hope: "You can achieve investment returns that beat the pants off even the best investment professionals," assures Joel Greenblatt in The Little Book that Beats the Market, from Wiley (www.wiley.com). "In fact, you can learn how it's possible to more than double the annual returns of the stock market averages," he'd add.

How is it possible, you wonder? The author, who is a hedge fund manager and professor, and `whose investment firm has averaged 40 per cent annual returns for over 20 years,' teaches how.

He begins with two lessons in the intro: "If you really want to `beat the market,' most professionals and academics can't help you, and that leaves only one real alternative: You must do it yourself." To help, Greenblatt offers `a magic formula' — that lets you choose `good companies at bargain prices.'

Figuring out what a business is worth isn't easy, concedes the author. "After lots of guessing and estimating, maybe you get it right and maybe you get it wrong. But what if you could? What if you could figure out what a business was really worth?" Greenblatt explores all these questions and more, through a story that takes you through the protagonist Jason's business plan.

The teacher in the author peppers the pages with narratives about financial analysis classes in an Ivy League university. For instance, he asks students if General Motors could be worth $30 billion one day and then a few months later be worth $60 billion. "Are they selling twice as many cars, making twice as much money, or doing something drastically different in their business to justify such a large change in value? Does something happen each and every year to account for large changes in the value of most companies?"

The answer is `No!' declares the author. "The prices of the shares in most companies swing around wildly each and every year. All you have to do is look in the newspaper to see that that's true." Why then do prices change so much if values don't likewise change? There are many `complicated explanations and theories' to reason why. But Greenblatt discards the same as `theories as to why something that clearly makes no sense, actually makes sense.' His answer is simple: "Who knows and who cares? Maybe people go nuts a lot."

According to Greenblatt, you don't really have to know why people are willing to buy and sell shares of most companies at wildly different prices over very short periods of time. You just have to know that they do! "It is a good idea to buy shares of a company at a big discount to your estimated value of those shares." That gives you `a large margin of safety'. You can become `a stock market master' by using just two simple tools, urges the author. "If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr Market has decided to literally give away." Companies that score the best on combined rankings are what should attract your attention.

Using Compustat's `Point in Time' database that goes back 17 years, Greenblatt constructs a portfolio of about `30 stocks that had the best combination of a high return on capital and a high earnings yield' and finds the return to be 30.8 per cent per year. "Investing at that rate for 17 years, $11,000 would have turned into well over $1 million," he explains. In contrast, the overall market averaged a return of about 12.3 per cent, and $11,000 would have turned into $79,000, as per the author's study. This, despite his formula doing worse than the overall market `for three years in a row'! Worth doing a similar exercise for companies closer home.

An insight of value is that most people don't have the patience to wait; their investment horizon is too short. "After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy - usually one that has done well over the past few years." Don't forget, `it's hard to stay with a strategy that doesn't follow along with everyone else's.'

Ben Graham had his own `magic formula,' points out Greenblatt. "Buying a group of stocks that could meet the strict requirements of Graham's formula was a great way to make money." The catch, however, is that "in today's market, few, if any, companies qualify for purchase under Graham's original formula." The alternative, as suggested in the book, being a ranking formula, doesn't have such a problem, says Greenblatt. The formula systematically helps you find `above-average companies' that can be bought at `below-average prices.'

But how do companies manage to achieve a high return on capital? By putting to use a `special advantage' that keeps competitors trailing far behind. "Businesses that don't have anything special going for them (such as new or better products, well-known brand names, or strong competitive positions) are likely to earn only average or below-average returns on capital." Keep a watch for companies that have "the opportunity to invest some or all of their profits at a high rate of return," because such an opportunity is `very valuable,' instructs Greenblatt. "It can contribute to a high rate of earnings growth."

Chapter 11 has an important warning: "Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot." Greenblatt emphasises more than once: "Most people have no business investing in individual stocks on their own!"

To him it is irrelevant to debate whether small-cap stocks outperform the large-cap ones and so forth. He also hopes that, "just as Mark Twain aptly referred to golf as `a good walk spoiled,' perhaps someday the random walk will finally be considered spoiled as well."

Fabulous read.

http://BookPeek.blogspot.com