Book Review: The Little Book That Beats the Market

Joel Greenblatt, a very successful hedge fund manager who also teaches investing at the Columbia University, promises to teach investors (including his children) how to produce market-beating returns with less risk with the help of a “magic formula”. He is not kidding with the “little” in the title: at slightly more than half the size of a regular hardcover, the book is only 155 pages long.

Setting aside the controversy (for a moment) about the actual returns produced by Mr. Greenblatt’s formula, I really enjoyed the book. There are so many personal finance and investing books to choose from and the vast majority are really old wine in a new bottle or sometimes the same wine in the same bottle with a new label. This book however is of the rare kind: it offers an original idea, is easy to follow and even if you are skeptical whether the formula will work in the future, it teaches the basics of investing using the example of a fictional business that sells bubble gum.

The magic formula presented in the book ranks stocks based both on the earnings yield and the return on capital (you can get a list of stocks selected by the formula on the Magic Formula Investing website. Use BugMeNot, if you want to bypass registration). The formula just attempts to find attractive businesses (with a high return on capital) that are selling at a bargain prices (a high earnings yield). Mr. Greenblatt has back-tested the formula on a point-in-time database (which eliminates survivorship bias) and says that a portfolio of 30 stocks selected using the formula and renewed every year would have returned 30.8% per year (compared to annual market returns of 12.3%) for the past 17 years.

There is some controversy over the margin by which the magic formula actually beats the market. For investors, this is a critical issue: If the formula triples the market return then it is probably worthwhile, but if it beats the market by just a few points, it may not be worth the extra drag of trading costs and ongoing capital gains taxes.

While I really liked the book and thought that the idea behind the magic formula made sense, I won’t be using it to select stocks for my portfolio. First, there is the chance that the excellent returns predicted by the formula might fail to materialize in the future. Second, the returns of the portfolio ignore trading costs and capital gains taxes. Having said that, the advice to buy good businesses at reasonable prices is timeless.

Another Book Giveaway: I will be giving away a copy of The Little Book sometime later this week (let’s say it is to celebrate Cinco de Mayo). Stay Tuned!