Suppose you’re a beginning investor who wants to invest for yourself but is not interested in doing all the work that’s involved with that undertaking. Nor do you want to abdicate control of your investments to the financial advisers out there as your not sure you can trust them (generally thinking, you would be wise in assuming this.) Joel Greenblatt’s third book which apparently few people have read is the perfect prescription…This man Greenblatt writes superb investing books…
Chapter 1: How to
beat the market
The Efficient Market Hypothesis
(EMH) which says that markets are efficient, and therefore it is not possible
to beat the market, other than by luck, is false. Still, beating the market can
be very difficult, even for highly intelligent, hard working people who have
attended top business schools. The secret to beating the market is in learning
just a few simple concepts that almost anyone can master, and that serve as a
road map. Even though the concepts needed to be a successful stock market
investor are simple and most people can do
it, it’s just that most people won’t.
Chapter 2: The secret
to successful investing
The secret to successful investing
is to figure out the value of something and then pay a lot less. The ‘a lot
less’-part is called the margin of safety. The value of a business comes from
how much that business can earn over its entire lifetime (20-30 years).
(Actually it is better to use cash flow instead of earnings, but in the book it
is assumed that earnings are a good approximation for cash received.) The
earnings need to be discounted to the present, which is called a Discounted
Cash flow analysis (DCF) to get the Present Value (PV). The problem with a DCF
is that 1) it is almost impossible to predict earnings for the next 30 years
and 2) small changes in growth rates and discount rates end up making a huge
difference in the present value.
Chapter 3: Other
valuation methods
Besides a DCF, there are also
other ways to determine the value of something. For instance, you can use a
relative value, acquisition value or liquidation value analysis. For larger
companies with multiple divisions, you can use a different analysis for each
division, and then combine the values of the divisions to get a
sum-of-the-parts value. But each of these valuation methods has its own
drawbacks and difficulties. So the main point is that it is not so easy to
figure out the value of a company. And if we can’t determine the value of a
company, we can’t determine an amount that we’d be willing to pay where we’d
have a margin of safety.
Chapter 4: Capital
allocation
An important part of investing is
capital allocation: you compare different investment possibilities to find that
ones that are most attractive, that is which you think will provide the best
risk-adjusted returns. The first hurdle an investment in a stock must pass, is
an investment in a 10-year US US
Chapter 5: Ways in
which individual investors can beat the market
If you’d want to beat Tiger Woods,
it would be best to choose a different game than golf. If you’d want to beat
professional money managers in investing, it is better to choose a style of
investing where they can’t or won’t compete with you. Some possibilities are
investing in small capitalization companies (small caps), focused investing
(where you analyze and invest in just a few companies where you have a special
insight or some deeper knowledge) and special situations investing (spinoffs,
bankrupties, restructurings, etc.) The drawbacks of investing in special
situations, is that they still require a reasonable amount of work and you
still need to have some valuation skills.
Chapter 6: Mutual
funds
If you don’t want to do your investing
yourself, you can invest in mutual funds. Mutual funds come in two flavors:
active and passive. In an active mutual fund an manager tries to invest in a
basket of stocks that will beat the market. In a passive mutual fund (also
called an index fund) the approach is to try to replicate the returns of an
index such as the S&P 500 by buying all or most of the stocks in that
index. This chapter focuses on active mutual funds. Managers of mutual funds
earn money through the fees paid by investors: the more money they manage, the
more they generally earn. So managers of mutual funds try to get investors to
invest as much money as possible with them, but this effectively excludes them
from investing in small caps (especially focused investing in small caps). Focused
investing in large caps is still possible, and though this has the chance to
outperform the benchmark, it also has the chance to underperform the benchmark
for long periods of time. And since investors in mutual funds usually don’t
have a lot of patience, they flee the mutual fund before it has the chance to
outperform. Since this is not what the managers want, they will generally not
invest in a focused way. Investing in special situation is also no option for
mutual funds due to a variety of reasons.
Conclusion: some of the most
effective ways to beat the market (as explained in chapter 5), can’t or won’t
be used by mutual fund managers. Therefore, most mutual funds don’t beat the
market, and because of fees, they don’t even match the market. Although there
are some superstar managers who manage to beat the market over longer periods
of time, 1) it is difficult to finds these managers ahead of time and 2) most
investors time their investments in the fund poorly: they come in after the
fund has performed well and they leave after the fund has
performed poorly, thereby realizing a much worse return than if they had stayed
with the fund for a long period of time.
Chapter 7: Index
funds
As we’ve seen above, it’s almost
impossible for most investors to value companies on their own, and hiring
experts (active mutual fund managers) also doesn’t work because most funds
under-perform the market and it’s very difficult to find that funds that will
outperform the market ahead of time. A good alternative is to buy an index
fund, like a fund which tracks the S&P 500 index. The advantage is that can
be implemented very cost-effectively and efficiently. The problem is that
investing this way is fundamentally flawed: since the index is market-cap
weighted (the larger the market capitalization of a company, the larger the
part of that company in the index), the more overvalued a company is the more
over-weighted it becomes (and vice-versa). So you end up systematically owning
too much of the companies that are over-valued and systematically too little of
the companies that are undervalued.
A better alternative to market-cap
weighted indexes are equally weighted indexes in which each
company has the same weighting. This adds on average 1-2% of return per year
over market-cap weighted indexes. The problem with equal weighting is that
these indexes can’t handle too much money due to the smaller constituents in
the index. Another alternative is fundamentally weighted indexes,
where the weighting of a company in an index is determined on the basis of one
or more fundamentals like earnings, sales, dividends, book value, etc. This
also adds on average 1-2% of return per year, and –unlike equal weighted
indexes– it can handle large amounts of money, since larger cap companies are
still overweight in the index, and also requires much less trading within the
fund. So fundamentally based indexes are a better way to replace market cap
weighted indexes than are equally weighted indexes.
Chapter 8:
Value-weighted index funds
An attempt to improve upon
fundamentally based indexes, is to use the value effect: companies that appear
cheap relative to earnings, book value, etc. have been shown to beat the major
market indexes by as much as 2-3% per year over long periods of time. So we could
design a value-weighted index in which the cheaper a company
appears, the larger its weight in the index. And while we are at it, why don’t
we add the philosophy of Warren Buffett and Charles Munger to the mix, and look
for companies that are not just cheap, but cheap and also good. Trailing
earnings yield (the earnings yields based on last fiscal year’s financial data)
can be used as a proxy for cheapness and trailing return on capital as a proxy
for quality (see ‘The little book that still beats the market’, also by Joel
Greenblatt). Had you done this over the last 20 years, you would have beaten
the S&P 500 by about 6% annualized (trading costs and market impact
modeled, but fund fees not included). When you use a value-weighted index, you
not only remove the systematic error that is present in a market-cap weighted
index, but you also add to the performance by buying more of stocks when they
are available at bargain prices.
Chapter 9: Staying
the course
The first part of the big secret
for the small investor, is to have the right strategy, which is to invest in
companies that are both cheap and good. The second part is that we need to
stick to the strategy over long periods of time. This is very difficult for
many investors to do, because –as research on the subject of behavioral finance
has shown– most investors are practically hardwired from birth to be lousy
investors: among other things they are impatient, loss-averse, have a herd
mentality, are focused on recent events and are overconfident. As we have
already seen above, value investing strategies can under-perform the market for
periods of multiple years. For very good investors this is a blessing in
disguise: if a strategy would work every week, every month and every year,
everyone would be a value investor and eventually the strategy would stop
working, because in that case the market would be truly efficient. For all
other investors, long periods of under-performance are a curse, because they
will be tempted to abandon their strategy much too soon and probably at
precisely the wrong time.
To help us deal with our human
flaws in the area of investing, we need a policy in which we first define what
part of our portfolio should be allocated to equities, and then how much that
part may vary over time. After we have done that, we need to stick to our
policy.
When we combine the strategy and
the policy, we have The big secret for the small investor: a new route to
long-term investment success.
Resources,
https://frankploegman.wordpress.com/2011/10/30/book-summary-the-big-secret-for-the-small-investor/
Postscript...
I live in Chapter Five
Postscript...
I live in Chapter Five
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