Book Review: The Little Book That Beats the Market
Sunday, April 20, 2008
The Little Book That Beats the Market is a quick and concise read about an investing system that author Joel Greenblatt truly believes will greatly outperform the market. I think there is validity to Greenblatt’s ideas, but I believe the book leaves a few key questions unanswered; and frankly, I’m skeptical of a book that contained the phrase “magic formula” on what felt like every page of the book.
Greenblatt’s system is actually quite simple: take the stocks with the highest return on capital, highest earnings yield, and rank them in a nice neat list; then buy a portfolio of the 30 highest ranking stocks, hold them for one year, sell them, and replace them with the newest high ranking stocks. Over time (specifically, periods of 3 years or longer) this system has beaten the broader market and the author provides compelling reasons to believe it will in the future. Essentially, Greenblatt’s “magic formula” is an exercise in value investing, albeit one where computer software runs all the calculations and the investor doesn’t really need to make any judgments about whether a stock is cheaply valued by the market.
The problem I have with this system of investing is that it ignores a critical challenge: transaction costs. Greenblatt goes into plenty of detail about why professional money managers fail to outperform the broader market and why mutual fund management fees are a major contributor to this problem. That’s a perfectly fair argument, and one reason why index funds and ETFs like the SPDR have become wildly popular in recent years. Greenblatt does plenty of number crunching to show that his “magic formula” outperforms the S&P 500 index fund, but it is all in a world free of transaction costs.
For instance, lets say you sign up for an account at a low priced stockbroker like Scottrade and deposit $10,000. Scottrade charges $7 per trade, or $14 per full transaction (buy and sell) and at 30 trades per year, that puts your cost of the portfolio at $420 per year, or 4.2% of your original investment. Certainly, 4.2% is a significant number when you’re trying to outperform a broader market average using a diverse portfolio of stocks. On the other hand, buying the SPDR will cost you 7 bucks the first year and nothing until its time to sell (assuming you don’t want to increase your position in the SPDR, but even if you do, lets say once a month, the transaction costs are still significantly lower than in the “magic formula).
Now, of course, as your portfolio grows, the transaction costs will decrease. A portfolio valued at $100,000 will pay less than 0.5% per year in transaction costs and a portfolio with a million dollars will pay peanuts in transaction costs. Unfortunately, for a novice investor or someone without much money to put in the market, the “magic formula” is a much less valuable than it is to someone with a lot of loose change to throw around.
The bottom line is that The Little Book That Beats the Market is very well written, short, and easy to read. I don’t really take issue with the style of investing proposed by the author or even that his “magic formula” is bogus; however, I do warn small investors from jumping on the bandwagon before considering the high cost of maintaining a 30 stock portfolio could actually have.
Posted by Rob Pitingolo 1:48 PM
