Thursday, September 17, 2015

The Little Book that Beats the Market, by Joel Greenblatt

** Updated 09-17-2015 **

In this magazine article packaged as a book, Mr. Greenblatt does a fine job of explaining the basic concepts of value investing. (That is, buy low and sell high.) He then promotes his "magic formula" approach which is to screen stocks for high return on assets (ROA), low price to earning ratio (PE). His formula is that by purchasing the 30 US domestic non banking stocks that are both the highest ROA and lowest PE, and resetting the purchases every year, one can dramatically out perform the S&P 500 or similar indices.

Mr. Greenblatt refers to his backtest (over 17 years in the older version of the book that I borrowed from my local public library) which confirmed that although there may be years during which his approach fails, in the long run it always succeeds. In his backtest he achieved an average return of 30.8% per year, compared to 12.4% per year for the S&P 500 in the same period.

This sounds great. I am, however, skeptical.  Primarily because Mr. Greenblatt did not provide any of his data sets. I'd really like to look at the stocks he chose and their underlying financial information.

To move forward, Mr. Greenblatt points the reader to his website,, from which you can get a screened list of stocks that meet his criteria. For free. So I checked it out. There were some surprises.

I generated a list of 50 stocks with a market cap over $50M (that's a universe that includes very small cap firms all the way up to very large cap firms). Unfortunately the list is presented in alphabetic order. So you can't figure out (without substantial manual labor) which firm has the best combination of {ROA,PE} and which has the next best, etc. Also, there no financial data on the list. Just the firm's name, ticker symbol, market cap, date of analysis, and date of quarter from which the data for the screen was extracted.

So which was the number one stock on this list? Well, we don't know! But we do know that the first one on the list, by virtue of the letter A, was Apple.  At least it is in the top 50 of firms out of the thousands in this screen. So let's think about Apple (AAPL).

On page 136, Mr. Greenblatt says that the minimum ROA should be 25%. As of this writing (per Apple's ROA is 17.09%. Its trailing PE is 13.47, which does seem low relative to the S&P 500. But I'm having trouble understanding how this combination of information put Apple on the top 50 list.

In the appendix, Mr. Greenblatt discusses return on capital, measured by pre-tax operating earnings (or EBIT) divided by the sum of net working capital and net fixed assets. And yield, as the ratio given by dividing EBIT by enterprise value (EV). I didn't compute the return on capital this way, but did look at EBITDA divided by EV; 11.6%. These are a bit different from the simple screen that Mr. Greenblatt explained earlier in the book, but pretty close.

Still surprised by Apple on this list, I looked at three other standard value screens. Historically, EV/Sales should be around 1.4; Apple's is 2.99. That's high (i.e., expensive).  Similarly, yield should be around 11%. That's okay here. Finally, Price/Book Value should be around 2.6 to 2.3; Apple's is 5.28 (i.e., too high).  Gosh, I'm still having trouble with Apple on this list.  And to be clear, I have nothing against owning Apple and I do believe that at current valuations it is a buy. But it is very difficult to imagine that it is one of the 50 best values out of the thousands of stocks from high-micro through small cap, mid cap and large cap, per Mr. Greenblatt's criteria.


The (to me) inexplicable presence of Apple on the screen continues to nag at me. Now I'm obsessing.

So I used the Google Finance screen (which isn't really sophisticated enough to replicate Mr. Greenblatt's model, but is at least a simple, free start) to look at domestic stocks with market cap greater than $460M, low PE ratio, high ROA.  The first one on their (ordered) list was Alliance Holdings (AHGP), a coal industry firm. This firm does not appear on Mr. Greenblatt's site, and clarity about why AAPL does and why AHGP doesn't would be super helpful.

AHGP's ROA is 14.11% and trailing PE is 7.92.  So on just the simple "magic formula" screen of PE and ROA, this sure seems a winner.  Against my other quick checks, it continues to look pretty good with yield at 27.5% (EV/EBITDA is 3.64) and EV/Revenue of 1.27.  Only the Price/Book ratio is high, at 3.63. 

The point of all this is, while I don't understand the coal industry well enough to know if Alliance is a good bargain at its current price, it certainly seems a likely candidate. The book should have sufficient information in it for me to discern why Apple and why not Alliance.

**End Update**

Bottom line: if this were just a magazine article about value investing, I'd have clipped it and shared it with my kids. But the "magic formula" to beating the stock market indices, even if it is completely accurate and repeatable, is not sufficiently well explained to convert me to play with my own money, nor to convince me this is a book worth recommending to others.

I guess if I could easily build the screens myself I might be more generous in my view, but that, even with tools like Value Line, requires effort.

The Little Book That Still Beats the Market (Little Books. Big Profits)

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