Book Review #30: The Little Book that Still Beats the Market: Author Joel Greenblatt

This is a sequel to the more famous book 'The Little Book that Beats the Market', by Mr.Greenblatt. This book is very easy to read and review since there is no new idea in this book. The book is a weak attempt to explain the 'Magic Formula' and is more of an effort to prove (to the sceptics) that the 'Magic Formula' works over time and over different groups of stocks.

What does an investor want? She wants to own shares of companies in the best business at very good market price. This is what Magic Formula tries to provide. Magic Formula itself is very simple. Identify the companies with the highest ROCE and the highest Earnings Yield and keep them for one year. At the end of one year, sell off them based on the tax rules prevalent in the country. High ROCE will ensure the attractiveness of the business and high earnings yield will ensure that the share is purchased at an attractive price.

How does MF work? Use a screener to screen companies with their ROCE in the financial year that just ended. Give the companies ranking from 1 thru N where 1 is given for the stock with the highest ROCE. Run another screen to identify the companies with their Earnings Yield. Use the same ranking to rank the companies based on the Earnings Yield with 1 for the highest Earnings Yield. Now sum up the ranks and buy the top 30 stocks with the highest cumulative ranks.

Magic Formula uses the following equations to calculate ROCE and Earnings Yield.

ROCE = EBIT / (Net Fixed Assets + Net Working Capital)

Earnings Yield =  EBIT / Enterprise Value (Market Value of Equity + Market Value of Debt)

The advantage of using EBIT is that it helps in comparison of performance of various companies without the complications of Taxation. The denominator in the ROCE equation is the cost of generating that EBIT.

As can be seen, Magic Formula is quite simple. However, there are some cautions.

1. If using the MF, one should have a portfolio of about 30 stocks to get the best returns. If an investor uses Magic Formula to buy one or two stock, he may end up losing. The reason is while the individual stocks within the MF may have fluctuating returns, as a whole, the formula works at a portfolio level.

2. For best results, spread the purchases of magic formula stocks. For example, buy about 7 - 8 stocks in a month for 4-5 months till you reach list of 30 stocks. This will even out the systematic risk.

3. Keep the stocks for at least one  year for the best results.

4. Do not keep stocks for more than a year (+/- a few days). Sell of loss making stocks before 365 days to get Short term capital loss benefits and sell profitable stocks immediately after 365 days to get the Long Term Capital Gain benefits.

5. Every year, run the formula again and buy the new stocks that meet the criteria.

Magic Formula works in US Contexts. For India Context, some tweaking may be required.

Mr.Greenblatt has an engaging style of writing interspersed with pithy witticisms. So the book is an easy read.  

This book did not add a lot of value to me. Probably the prequel might. However, that book is very expensive and I am waiting for a correction to buy that book.

My score is 3 / 5 for this book.