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:

What's the Big Secret to Riches?

There are two schools of thought when it comes to investing in stocks. One is growth and the other is value. Warren Buffett believes that these two strategies are "joined at the hip" and that you cannot think of them separately. So what are the main differences between these two types of investment styles.

A growth investor is looking for companies that are expanding quickly. Typically these companies don't pay a dividend since the earnings are reinvested into the company so it can "grow" faster (such as Research in Motion). Whether the funds are used to grow the company faster than you could by investing the earnings elsewhere is questionable. In this case you are looking to buy these companies at a high price, hoping that the price will continue to climb.

Value companies on the other hand are companies that have good valuation metrics such as price to earnings or price to book value. Value purchases are made when the economics of the industry may be out of favour or the company has hit some kind of snag that is solvable. Usually the price will reflect these uncertainties and for that reason it may appear to be a bargain (but be aware it might be cheap for a reason). Value companies tend to offer a dividend which can be invested elsewhere or can be used to maintain your quality of life. In this case you are looking to buy low and sell high (although you could hold on to the stock for it's sweet dividends).

So what is the best investment strategy. In "The Big Secret for the Small Investor"by Joel Greenblatt, he makes a strong argument that value investing is the way to go. Be warned that I am biased, I would classify myself as a value investor so I tend to read books about value investing. This book is more than just a sales pitch for value investing, it gives deeper insight into an age old strategy of investing known as index investing.

Index investing is when you purchase mutual funds or ETF's that mimic the entire market index (TSX, NASDAQ, DOW, or S&P 500). This is a great passive way of participating in the market that will be sure to beat approximately 70% of actively managed portfolios (most of which is due to the low management fees, low portfolio turnover and transactional costs). When it comes to finding the perfect stock it can be analogous to finding a needle in a haystack, so index investing is like purchasing the whole haystack. Greenblatt goes above and beyond by testing out different index fund strategies.

Something he's noticed is that market indices are usually market capitalization weighted, meaning that as a singular stock price rises, the index causes you to own more of that stock. So what if that stock is overvalued? In this case your portfolio would be over weighted in overvalued stocks and we all know what happens when a stock is overvalued. The price increase won't continue forever and when bad news eventually surfaces a price crash ensues.

So what's the best solution. Consider an index fund oriented towards value investing, which would set up the weighting of your portfolio a little differently. Causing you to buy more of what is out of favour so you purchase more undervalued stocks (buying low selling high). This balances out your portfolio and produces higher rates of return in the long run.

Here are some wise words from the Oracle of Omaha himself: