A Financial Revolution 

March 03, 2006
Joel Greenblatt's Little Book Tells Us How to Beat the Market
Last night I finished Joel Greenblatt's new book, The Little Book That Beats the Market. It's a well-written, easy-to-understand, funny and short book that promotes a "magic formula" which has beat the market by a wide margin over the last 17 years.

The simple formula identifies businesses that are well-run (high return on capital) and selling at a bargain (high earnings yield). According to the author, if you invest in the top ranked 20 to 30 companies each year, you will top the market averages over the long term. Why 20 to 30 companies? Because some of the companies are bargain priced for very good reasons so the goal is to identify stocks that on average will rise faster than the market. An investor following the formula would simply buy the top ranked 20 to 30 companies every year without ever reviewing a financial statement or even considering the future prospects of a business. Mr. Greenblatt even provides us with a list of the formula's top ranked companies at magicformulainvesting.com (currently free).

While I recommend the book and believe the formula has merit (based on past results), I think Mr. Greenblatt failed to discuss one important criteria: minimum portfolio value. How much money would I need in order to follow this formula? Buying and selling 30 stocks every year is an expensive proposition. If we assume a transaction costs $20, that would amount to $1,200 per year in transaction fees. On a small portfolio, say $25,000, the transaction costs would cut your return by a full 5% each year and, assuming the costs are paid from the $25,000, reduce the amount you have to invest. Most of the articles and books I've read suggest keeping transaction costs to below 1%. Using that guideline, an investor would need at least $120,000 to follow the magic formula (less if the investor used a cheaper discount broker.)

I don't plan to adopt the automatic magic formula approach (i.e., buy the 20 to 30 top-ranked stocks every year), but I do hope to use the suggestions in the book for stock ideas and to better evaluate the stocks I research.

Anonymous Nathan Whitehead said...

That sort of strategy sounds perfect for an account with FOLIOfn. (www.foliofn.com). For $200 annually, you get up to 50 individual stocks with as many trades as you could ever possibly need. With the 1% rule, this would be $20,000 minimum investment. It also has fractional shares, rebalancing, and tax loss management. If the formula is picking really oddball stocks, FOLIOfn might not cover them, but they cover most major stocks.

Myself, I don't think you can beat the market with a static little formula. I'm more of an efficient market hypothesis guy. I like my ETFs.

3/12/2006 10:57 PM  

Anonymous Market Participant said...

In a few months first trust is going to start an ETF that is based on Economic profits (I.e return on capital in excess of the cost of capital), it's going to be called the First Trust DB Strategic Value Index Fund. It should be interesting to see how this fund performs.

Market Participant

4/11/2006 2:14 AM  

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4/29/2006 3:16 PM  

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