The Little Book that (Still) Beats the Market - Greenblatt

Joel Greenblatt is best known for his success at Gothem Capital, as well as being a cofounder of the Value Investors Club, and his work as a professor at Columbia's business school. This book was designed to show an effective way of beating the market/equity index funds for a more passive investor. These are considered the basic concepts of investing.

#1 Basic overview on how to read an income statement:

Revenue/Sales is the top line
- Cost of Goods Sold
Operating income
- Selling General & Administration
Income before Taxes (EBIT)
- Taxes
Net Income

If just starting to review financials, the is a decent starting point. Page 22

Not covered: Advancing your ability to interpret SG&A can be one way of getting an edge on the market. This is because a great deal of SG&A can be intangible assets that add future value to the company. Accounting has not changed how intangible assets are documented, and they are usually expensed here. You can read more about this from Michael Mauboussin here:

He also references the book which explains this in further detail: The End of Accounting and the Path Forward for Investment Managers and Investors

#2 Understanding a share, and why price does not matter. This is a very elementary concept, but worth noting for new investors. Stock price does not matter relative to other companies because the stock price is the price of the entire company divided by the number of shares. What you should care about is the net income (earnings) your share represents. If a company's net income (earnings) is 100 million dollars per year and they have 100 million shares, your earnings potential is $1. You must compare this with the stock price (earnings per share / stock price) to determine the earnings yield. Page 37, 169

A more accurate earnings yield = EBIT / EV
This shows companies more apples to apples with respect to differing debt and taxes.

#3 Chapter 5 is the most important chapter in the book. Greenblatt outlines his most important values for each company. Earnings yield (just discussed above) and ROIC (return on invested capital). Simply put earnings yield tells you how cheap the stock is, and ROIC tells you how good the company is. ROIC is measuring how much a company makes relative to the capital costs for the business to run. Summary on pages 47-49.

Details on measuring ROIC are provided on pages 166-172. For his calculations he uses:

ROIC = EBIT/(Net working capital + Net fixed assets)

EBIT is more accurate than earnings or net income because capital structure and tax rates are eliminated.

Net fixed assets are the depreciated assets needed to run the company, he then adds net working capital to determine how much is needed to fund inventories and receivables. Net working capital = current assets - current liabilities. Important to note he excludes "excess cash not needed to run the company" (cash in excess of 5% of revenues) and short term debt on liability side.

IMPORTANT: Intangible assets were excluded. This maybe important.

#4 The Magic Formula. His book starting with Chapter 6 summarizes that if you were to rank all stocks based on earnings yield, and separately based on ROIC, you could then add together the two rankings to get an aggregate ranking. If you were to pick the top 30 stocks from the aggregate rankings you would beat the indexes close to 100% of the time when measured over a 3 year window (to account for Mr Market's volatility).

A passive investor may choose 'The Magic Formula' route over index funds and achieve higher returns consistently. There are some nuances to the strategy that he discusses in the book if considering. His website outlines the top 30 stocks using his methods of calculating.

For individual company investors he does a good job outlining the two most significant variables in security analysis:
- Earnings yield, as a measure of 'cheapness'.
- ROIC, quality of the company and ability of management to reinvest earnings.

Paul Weaver

Charlotte, NC