This book is a classic when it comes to pinpointing what it takes to come up with successful stock market investing. The formula that the author describes is to seek out good stocks when they are available at bargain prices, i.e., above-average quality company stocks at below average prices, i.e., so-called value stocks, or value investing, made so famous by investment gurus such as Warren Buffett. The present book delineates the key principles of value investing in a simple, straightforward way.
The first edition of this book was published in 2005. The principles for investing that the author came up with then remain the same in this new edition, but the author has written a new introduction as well as an afterword.
This classic book on investing is perhaps one of relatively few. In this reviewer’s opinion, this book’s focus on creating successful stock portfolios based on the purchasing of undervalued, high quality stocks, compliments very well the thesis for investing laid out by Pabrai (The Dhandho Investor, (2007), Wiley), which focuses on finding “safety cushions” that might be sold off during adverse times, as well as Svensen’s Unconventional Success (2005), which focuses on developing a wider range of asset classes as a basis for growing a value-based portfolio of investments. All of these books are more than 15 years old, but still are indeed relevant and valid as far as this review is concerned.
The key points in Joel Greenblatt’s book are very simple, but powerful. But, before reviewing these issues, let us re-state the author’s key formula for success in the stock market. “Only buy shares in good businesses (ones with high return on capital) but only when they are available at bargain prices (priced to give us a high earnings yield)” (page 54). This does indeed seem like value investing par excellence, and quite similar to what has made Warren Buffett and other investors very successful.
Going back to the chronology of the book, the author states that his method requires discipline, and calls for a long-term time horizon. Importantly, this approach must stand the test of making sense to individual investors.
The author stresses the importance of getting one’s money to work. The riskier one engages, the higher the returns one might expect, such as relatively higher returns on riskier loans. Self-evident! And when it comes to valuation of stocks, this a clearly a function of future earnings. Again, the riskier the expected income stream from a given stock, the higher valuation, in contrast to more or less risk-free government bonds, which tend to yield zero interest or close to zero at best.
To figure out what a business is worth is not easy, the author admits. But while the value of most companies tends to remain relatively stable over a year, the prices of most stocks tend to move around frequently – market expectations are at work! One should try to buy particular stocks when its market price is down, so as to establish a comfortable margin of safety. To develop a sound business portfolio one should stick to buying good companies (ones that have a high return on capital) and to buying these companies at bargain prices (at prices that give a high earnings yield). Such companies also tend to be able to reinvest a lot, thus having a higher return-on-capital than most “average” companies. An ultimate goal might perhaps be to buy shares in companies that happen to be priced at net liquidation value, so-called bargain issues, or net current assets stocks. So, to come up with a simple system could lead to consistently good investment returns. The morale would be to buy in good companies when they are available at bargain prices, and to try to come up with a simple formula for such buying. But as was pointed out at the outset of the book, for such a magic formula to work, one must maintain a long-term investment horizon. We know, for instance, that to purchase so-called indexed-priced stocks have largely been in vogue for the last few years, until recently, in contrast to value stock-picking/value investing. Thus, long-term commitment to the author’s principle is key!
We have already pointed out that to have an opportunity to be able to invest in a stock that produces a high rate of return can be very valuable. Companies that earn high return generally also allow for such an investments opportunity, i.e., to reinvest rather than to “pocket” dividends.
To choose stocks without having explicitly what we might be looking for might be highly risky. A clear value investment strategy would be needed. But to make such investment decisions on one’s own on a long-term basis might be next to impossible. The amount of time is takes, also entailing heavy work and a great deal of hassle, one could be better off working through a good fund manager who may be good at value investing. In theory, however, there would be nothing to stop individual investors to make the required assessments needed and thus, to do the investing themselves – it is all a matter of ability to put in the hard work! However, the author warns against using most stockbrokers in order to find good fund managers, getting involved with mutual funds, and staying away from hedge funds as well. Well managed index funds seem to be acceptable, however, but it should be kept in mind that to search for good deals must be central for the way such a fund is managed, rather than more or less mechanically following a given index. To avoid excessive trading might typically be dysfunctional, in the sense that one may not get an effect similar to earning compounded interest, in addition to also having to pay a lot of trading fees, of course.
The author concludes his book by offering a set of step-by-step instructions. To identify “good buys” he suggests visiting the link magicformulainvesting.com, a screening tool created specifically for the book. Alternatively, one might use ROA as a screening criterion. The author suggests a minimum ROA of 25%. From this group of stocks, one should screen for these with the lowest P/E ratio. However, all utilities, financial stocks (mutual funds, banks, insurance) as well as foreign stocks, should be excluded. Special attention might be given to stocks that simply have a two low P/E ratio, say 5 or less. To be on the safe side, such stocks might be eliminated too. There might simply be hidden risks of something fundamentally wrong in such cases. Finally, firms that have recently announced earnings results might be eliminated from one’s list too.
An investor might aim at building up a portfolio of say, 30 or stocks from this list. To find all these stocks at once may be totally unrealistic of course. Instead, one might aim at developing one’s portfolio over time, say, by purchasing a few stocks per month (5-7). And every stock holding should, in turn, be sold after one year. New stocks should then be purchased, again, following the same selection principles as before. In this way, an actively managed stock portfolio is created and maintained, built on sound value-investing principles. As the author states in his afterword, it is all about following a disciplined strategy, which is based on a long-term stance in looking for a strong, positive yield from one’s portfolio.
This book has become a classic. It is simple, indeed. But it is totally clear, which might be contrasted to what we find in many books on stock investing. As noted, this book, together with the books by Pabrai and Svensen, should occupy central spaces on every successful investor’s desk. The book is as relevant today as when it was written some 20 years ago. Highly recommended.
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