THE LITTLE BOOK THAT BEATS THE MARKET (BY JOEL GREENBLATT)

Summary

In this video, we dive into Joel Greenblatt's *The Little Book That Beats the Market*, exploring his 'Magic Formula' for stock investing. The script outlines key insights, including how stock prices often fluctuate irrationally, the challenges of valuing businesses, and the importance of metrics like P/E ratio and ROA in identifying profitable investments. Greenblatt’s formula—focusing on low P/E and high ROA—has been backtested to outperform the market significantly. The video concludes with step-by-step instructions on how to apply the formula in real-world investing to build a successful, long-term portfolio.

Takeaways

• 😀 Market prices are volatile and often don't reflect the true value of companies. Stocks can fluctuate dramatically, regardless of business performance.
• 😀 The stock market is influenced by irrational factors like fear and greed, causing overreactions to news that don't always align with a company's actual worth.
• 😀 Estimating the value of a business is challenging because it's difficult to predict future earnings, making it hard to determine a fair price.
• 😀 P/E ratio is a useful metric to assess whether a company is priced attractively, with lower P/E ratios indicating better value for earnings.
• 😀 Return on Assets (ROA) shows how efficiently a company uses its assets to generate profit, and a higher ROA indicates a better business model.
• 😀 The Magic Formula, created by Joel Greenblatt, involves buying high-quality companies at low prices based on P/E and ROA. This strategy has historically outperformed the market.
• 😀 By investing in companies with low P/E ratios and high ROA, investors can uncover hidden bargains that will likely perform well over time.
• 😀 The Magic Formula's success can be seen in its backtests, where it outperformed the market by 18% annually over a 17-year period.
• 😀 A key part of the Magic Formula is to regularly rebalance your portfolio by investing in the top-ranked companies from the formula's screening process.
• 😀 Following a structured, step-by-step approach with the Magic Formula can help you build a diversified portfolio and potentially achieve superior long-term returns.
• 😀 While the Magic Formula simplifies the investing process, it's important to remember that it’s based on historical performance, and results may vary in the future.

Q & A

What does Joel Greenblatt compare choosing individual stocks without knowledge to?

Joel Greenblatt compares choosing individual stocks without knowledge to running through a dynamite factory with a burning match, suggesting it's risky and foolish without proper understanding.

Why does the stock market fluctuate so dramatically according to the script?

The stock market fluctuates dramatically because it is often driven by overreaction to information, resulting in irrational price movements that do not reflect the actual value of companies.

How does Joel Greenblatt suggest we assess the value of a business?

Greenblatt suggests that assessing the value of a business requires estimating both short-term and long-term profits, while considering how confident we are in those predictions. The value must also factor in the potential for earnings over the next 5 to 10 years.

What are the two key metrics Greenblatt emphasizes when evaluating businesses?

The two key metrics Greenblatt emphasizes are Price-to-Earnings (P/E) ratio and Return on Assets (ROA). These are used to assess both the price and the quality of a business.

What does a low P/E ratio indicate about a company?

A low P/E ratio indicates that a company is potentially underpriced relative to its earnings, meaning it could be a more attractive investment compared to companies with a higher P/E ratio.

How does Return on Assets (ROA) relate to a company's investment appeal?

Return on Assets (ROA) measures the efficiency with which a company uses its assets to generate profits. A higher ROA suggests that a company is using its resources more effectively, making it a more appealing investment.

What is the 'Magic Formula' that Joel Greenblatt introduces?

The 'Magic Formula' is a strategy where companies are ranked based on their combined score of high ROA and low P/E ratios. This formula helps identify businesses that are both good in quality and priced attractively.

How did the Magic Formula perform in backtesting over a 17-year period?

The Magic Formula outperformed the overall market by about 18%, returning 30.8% per year compared to the market's 12.3% per year. Over 17 years, a $10,000 investment using the Magic Formula turned into nearly $1 million.

What is the recommended approach for using the Magic Formula to build an investment portfolio?

To use the Magic Formula, you should buy between five and seven top-ranked companies, investing 20%-33% of your capital at a time. Repeat this every two to three months until all capital is invested, aiming for a portfolio of 20-30 stocks.

What does Joel Greenblatt say about the results of using the Magic Formula?

Greenblatt acknowledges that not every investment made using the Magic Formula will be successful, but on average, it helps identify true bargains and outperforms the market over time.