The Third Pig

The following commentary is taken directly from Brick Financial Management's November 2005 letter to clients.

The Little Book
Instead of getting into the details of our portfolios this month, we thought we’d change things up a bit with this letter. Recently, a neat little book hit bookstores. Written by hedge fund manager, Joel Greenblatt, The Little Book That Beats the Market explains value investing in (mostly) layman’s terms. The book touts a “magic formula” that Greenblatt says will help any investor beat the returns of the market. A review from the University of Western Michigan Library states:

“Using basic math skills and simple concepts, Greenblatt shows you how to achieve investment returns that beat the pants off even the best investment professionals and the top academics… Through entertaining anecdotes and practical pearls of wisdom, the book explores the basic principles of successful stock market investing and reveals the secrets to buying good companies at bargain prices automatic… The (magic) formula has been tested over hundreds of different periods and thousands of stock picks and has been proven extremely profitable for those who are willing to stick with it...”

Good companies at bargain prices The book is of particular interest to us and the clients of Brick Financial because it so clearly lays out basic value investing principles that we follow every day. Basically the book is about how to find superior companies at bargain prices. Greenblatt’s magic formula helps investors identify those companies.

Following the formula requires caution
Greenblatt goes to great lengths to explain to the reader that the magic formula is not a panacea. The formula is bound to lead to some years of underperformance. [Even proven investors have down years.] Those that don’t have the conviction or where-with-all to stick with it are bound to abandon the approach. Thus, following the formula requires faith in the underlying principles of value investing. It requires the ability to endure the long-term. And it requires, as Warren Buffett has stated, a “quality of temperament…not a high IQ”.

He is also adamant in saying that you should not be investing directly in stocks if you do not know the principles of accounting, forecasting, and basic financial principles. If you can not confidently work your way around a company’s financial statement then, according to Greenblatt,

“You have no business investing in individual stocks on your own!... Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

Highlights of The Little Book
Some of the main points of the book, and those that are most relevant to clients of Brick Financial, follow:v

• There is a place where they sell businesses for half price all the time. And it doesn’t take a genius to figure out where to find them. The trick to finding these one dollar bills for 50 cents is that you as the investor must believe that these “dollars-on-discount” exist. Everyone should endeavor to save money. There are places an investor can put his money – under a mattress, in the bank, in government bonds or in corporate bonds. Some investments are better than others though.
• Buying a stock means buying a percentage share in a business which entitles you to your proportional share of that company’s future earnings. Estimating the current value of the business requires guessing what the future earnings of the business will be. Your investment in any company should offer you more of a return than you might get in “safer” alternatives like the mattress, bank, or bonds.
• Most stock investors are irrational and speculative which is one reason why the prices of stocks swing wildly in short periods of time. For instance, GM’s stock price can go from $30 to $60 in just a few months. It is improbable that the value of the GM would double in that time. Does this phenomenon make any sense? No! But all we as investors need to know is that it occurs and attempt to exploit it. We don’t need to know why it occurs. Even though it is difficult to value business, we must make our best guess. And when we do decide to invest, we are best served to wait for the moment when the stock price of the company is below our guess of the business’ intrinsic value. Benjamin Graham coined this action as buying with a margin of safety.
• It is better to buy a company that earns more money relative to the amount you paid for it. In other words, if company A earns $2.40 per share per year and company B earns $1.20 per share per year, yet both companies cost you $12 to purchase, which is the better buy? Company A of course. You’re getting more earnings for your money. Company A’s earnings yield is 20%, while company B’s is only 10%.
• An investor would also be keen if he bought only good business. How do you tell which are the good business? As an example, let’s say it cost both company A and B $400,000 to build each of their widget stores and get up and running. Let’s further say that company A earns $200,000 but company B only earns $10,000. Which is the better business? Company A once again. Company A’s return on invested capital (ROIC) is 50% while company B’s ROIC is a paltry 2.5%.
• If an investor stuck to buying good business (high ROIC) at cheap prices (high earnings yields) he’d do well with his investments.
• Buying good businesses at bargain prices works as an investment strategy. Not only has it worked in the past but because its principles are sound, it will work in the future. There will always be better business than others and there will always be better values than others. But the investor must have faith in the principles.
• The “magic formula” as well as any well reasoned investment strategy will occasionally fail to do well in the short-term. The short-term can often mean years, not days or months. It is extremely hard to stick with a strategy that may not work for several years in a row. Which is a good thing. If the formula worked all the time, everyone would use it and it would eventually cease to work. The trick is to have a long-term mindset. Long-term in this case means three, four, or even five years or more!
• Although you want an investment strategy that has worked in the past, a good track record will not ensure results in the future. A good track record will not keep you following if the results are not as good. You should follow an investment strategy if the principles are sound. Buying good businesses at bargain prices is a sound principle and is the definition of value investing.
• If an investment strategy is sound, the longer the time horizon, the better the chances for success. Time horizons of 5, 10 or 20 years are ideal. Such a time horizon will give an investor a large advantage over most other investors.
• As much as 95% of the trading that occurs in the stock market is completely unnecessary and meaningless.
• The stock market offers the best possibility for high investment returns over time. However, most people that should invest should not invest on their own. So it is difficult to know where to start. Stockbrokers generally have NO idea how to help investors. They’re only trained to sell products at the investor’s expense. Mutual funds would be fine but the vast majority of mutual never beat the market. A hedge fund may be a viable option but their high fees are usually not justified by their performance.
• Since there are so few good avenues for investors to participate in the stock market, the best choice is most often an index fund. Or he may use an easy to use “magic formula” like the one in the book.

Be sure to get the book Finally, we encourage you to read this book. You can click this link to pick up a copy. You can also view a review by The Wall Street Journal here.