Archives for November 2006

Almost a perfect counterpoint to The Little Book That Beats The Market (review), this book could easily be titled The Big Book That Shows You Can’t Beat The Market. It weighs nearly 5 pounds, and is almost 400 pages long. This thing is a beast!

Instead, the title is Index Funds: The 12-Step Program for Active Investors. This is actually a pretty good title as well. Instead of starting at the pure beginner level, it assumes that you know a little bit about the market. Maybe you’ve dabbled in stocks, or have some hot mutual fund picks on your 401(k). The basic layout of the book is this:

1) Present an active-trading idea, and then
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There’s been a lot of buzz about The Little Book That Beats the Market, so I was excited when it finally came in from the library. Of course, at the time I was midway through Index Funds: The 12-Step Program for Active Investors, which I’ll also be posting a review about shortly. Alternating between the two books was like a roller coaster – the Little Book fanning the (little) stock-picking flame inside me, and Index Fund book trying just as hard to stamp it out forever.

The Little Book is well, really little. It’s about the size of a 5″x7″ photograph and barely over 100 pages long. It could be easily finished in one afternoon. The writing style is simple and easy to read, although many of the jokes felt a bit forced to me.

It starts with a nice little story which explains what you are actually buying when you purchase a stock. In short, you’re not buying a physical object, but a stream of future earnings. This is why stock prices fluctuate so much – you’re trying to predict the often-hazy future.

Accordingly, Greenblatt argues that the Market is simply crazy over the short term. But due to this craziness, there is the opportunity to snap up a company at a bargain price. Enter the Magic Formula: Buy good companies at bargain prices. Doing some number-crunching, using the formula gives you historical annual returns of about 30%, beating the market by 20% every year. All with lower risk than the market. Yowza! Sounds good right?

The tricky thing about this book is how ‘good’ and ‘bargain’ are defined. Greenblatt uses a vague definition in the main part of the book, and then a more complicated definition in the appendix. Thanks to JLP at AllFinancialMatters, I discovered this Barron’s article which confirms that even other quantitative people can’t understand the exact definition of the Magic Formula or replicate his awesome returns. They used a different stock database, leading to the returns going down significantly. That’s a bit fishy.

But… even if you use his dumbed-down (my name, not his) definitions of:

Good = High Return On Assets (ROA), and
Bargain = Low P/E ratio,

both of which are part of most stock screeners, you still get market-beating results.

Criticisms
Any time a book claims to beat the market, people line up to crap all over it. I mean, isn’t this just good ole’ Value investing? Traditionally this is done with other ratios like Book-to-Market ratios. Again, the data seems to support that the Little Book method does better than other ratios.

Another criticism, which is noted in the book, is if everyone knows this secret, won’t the prices adjust and remove this market inefficiency? Greenblatt counters this with the fact that his method only works for the long-run, and will underperform the market for sometimes years at a time. This volatility will scare away enough investors and/or fund managers over the long haul such that the premium will endure. Okay, maybe.

My personal nitpick is that the returns also don’t take into account trading commissions and bid-ask spreads. Greenblatt glosses over this point by implying “This method kicks so much ass (remember, 30%!) that you could pay full-service broker commissions and you’d still come out ahead!”

But let’s take a closer look. He suggests holding 30 stocks, each for only a year. Unless you’re investing huge sums, that’s a big drag. If you buy in $500 chunks ($15,000 total portfolio size) with $10 trades, that’s a 4% dent in profits every year (buy and sell). Even at $5 trades, that’s 2%. Finally, if you’re not holding these in an 401k/IRA, you’ll have to deal with taxes.

Added:
1) His returns were based on data from 1988 to 2004, which may be the best he could get will full data, but still is less than 20 years. Will it persist?
2) The book has a website, MagicFormulaInvesting.com, which you can generate the current picks per the Little Book method.

Conclusion
So, if you add in the database inconsistencies, smaller future market inefficiencies, the existing value-premium, the trading costs, and taxes, will you still end up with a risk-adjusted market-beating return for the next 20 years? I have no clue. I can only say that I’m not changing any of my current investments, but if I do eventually set up a small stock-picking portion of my portfolio, I’ll keep the results of this book in mind.

Although I don’t really recommend it as an investing guidebook like The Four Pillars of Investing, I did find it a fun book to read. I think it presents a new-ish view on picking stocks and was a refreshing change of pace for me.

Overall Rating: (ratings explained)