Monday, September 3, 2012

Trying to Beat the Market?

Joel Greenblatt has done it again. Here's written another excellent book that breaks down the complex subject of investing in stocks into a way that anyone could understand. Greenblatt is also the author of "The Big Secret for the Small Investor." I'm a huge fan of the Greenblatt's down to earth investment strategies. He's what the industry would term a "value investor". In "The Big Secret for the Small Investor" Greenblatt recommends investing in value oriented index funds. To understand this concept it's best to read the book itself, but to put it in a nutshell, indexes usually weight the holding of stocks based on market capitalization. The danger lies in being weighted to heavily in stocks that have reached unreasonable highs. Thus, you would not be following the old adage of buy low, sell high if you are investing in a regular index fund. A value index fund differs in that weighting of the holdings. There are several different ways this can be done, but the important thing to understand is that the way your holdings are weighted in an index fund can help you improve your overall investment return.

In "The Little Book that Still Beats the Market", Greenblatt discusses two main metrics that should be looked at when choosing individual stocks in your portfolio. These two important metrics are earnings yield and return on capital. Earnings yield measures the same thing as the price to earnings ratio (PE) and is simply the inverse of the PE.Typically, you look for a low PE (for a value investor) because it means that you are paying less for a dollar of a company's earnings. Earnings yield is the exact opposite, so in this case you're looking for a high earnings yield.

For example, if a company earns two dollars per share a year and the shares are selling for 10 dollars a share the price to earning ratio would be (10 divided by 2) 5 and the earnings yield would be (2 divided by 10) 0.2 or 20%. Both numbers are measuring the same thing, which is the price you are paying for a dollar of a company's earnings. So whether you're looking at a low PE or high earnings yield, you're still trying to look for the best bang for your buck. This metric tells you whether you're getting a company at a bargain price.

The second metric is the company's return on capital. This statistic measures the ability of a company to convert the company's capital to earnings. For example if you invested $10 to start a lemonade stand (i.e. signs, chairs, cups, lemonade, etc...) and made $20, your return on capital would be 2 or 200% (20 divided by 2). The higher the number the better, meaning that the company is efficient at using it's capital to generate earnings.

Putting it altogether, Greenblatt recommends ranking companies by their earnings yield and return on capital choosing company that have both high earnings yield and return on capital. It's important to find both factors in the stock because it means you're buying an excellent company at an excellent price. Knowing this why wouldn't everyone be doing it. Greenblatt explains that this strategy can lead to short term under performance, but over the long term (5+ years) you can expect returns that exceed the market average.

Keep savin' and with your savings be sure to get your money working for you!

Here's Greenblatt discussing the investment strategy in this book: