28 February 2017

Book review: The Little Book that Still Beats the Market

The JM Finn & Co book club, consisting of a dozen or so investment professionals across the firm, was conceived in 2017 with the hope being that, month by month, some of the wisdom of investing gurus such as Warren Buffet, Charlie Munger, and Mohnish Pabrai, might rub off on their eager selves.


The first book we chose to read and discuss was The Little Book that Still Beats the Market by Joel Greenblatt. Joel is the founder of the investment partnership Gotham Capital. For the 20 years after its inception in 1985, he produced 40% annualised returns – he seemed a suitable candidate to try to learn from!

As the title suggests, his book is intended to help investors to achieve above average results, be they novices or experts. He writes in an approachab le, and at times conversational, manner which can be easily digested, regardless of previous knowledge of the intricacies of the financial world. Plus, it is as advertised: ‘little’ - totalling just 180-odd pages.

His mantra is simple; buy above average companies at below average prices. Simple right?

What makes an above average company? In his view, the most important metric for this is how effective the company is at generating a return on the capital they pump into the business. There are various industry standards for measuring this ability including; return on equity (ROE), and, his favoured option, return on capital (ROC). Standard definitions are as follows:

ROE = net income/ shareholder’s equity
ROC = net income/ capital employed

Net income is affected by interest payments (and therefore debt levels) and by varying tax rates. Therefore, Joel argues that earnings before interest and taxes (EBIT) should be used instead to give a fairer comparison amongst companies in different tax jurisdictions and with varying degrees of leverage.

He also makes various other tweaks to the standard form which I won’t go into, but I would encourage anyone with a keen interest to look it up in his book. That said, in order to illustrate the main differences, and subsequently the advantage of his form of ROC, consider the following example.

Scenario 1
You buy a flat for £100k in cash that you intend to rent out. The net operating income (rent minus all expenses before taxes) generated is £6k a year.

This generates you a 6% return on capital.

Since you bought it with no debt, your equity is also £100k, and so your return on equity is the same; 6%.

Scenario 2
You pay a deposit of &po und;20k towards the same £100k flat, taking out a mortgage on the rest. The interest rate on your mortgage is 5%.

Your return on capital is the same; 6%. However, consider the ROE:

The rent that comes in is still £6k, but now you have to pay 5% on £80k, or £4k, in interest. So your new net operating income is £6k - £4k = £2k. Your equity, since 80% is borrowed, is 20% of £100k, or £20k. So your ROE is now £2k/£20k = 10%.

Looking on a ROE basis, scenario 2 looks much better. But in fact, the flat is still the same, the monthly rent is still the same – nothing about the earnings power of the flat has changed. The use of leverage has unjustifiably flattered the appearance of the investment when ROE is considered. 

ROC looks through the effects of leverage, and for that reason Joel Greenblatt, and now the converted members of the book club, much prefer this metric.

So, now how to pay below average prices.

For this Joel considers two numbers. Firstly, the enterprise value (EV), which is the market value of the shares + market value of the debt – the cash. This is effectively the price you would have to pay to acquire the business. The second is EBIT which we have discussed above. The ratio of these (EV/EBIT) gives an indication of how expensive a company is relative to its ability to generate earnings.

Armed with his two indicators, Joel then screens his entire universe of stocks. They are given a rank based on an equal weighting of how high a ROC, and how low an EV/EBIT. He suggests buying a portfolio of the top 30 or so stocks based on this ranking, re-evaluating on a yearly basis, and Bob’s your uncle.

Of course, there are a plethora of reasons why this app roach does not translate simply from theory into practice. But there is a lot to be said for using these metrics as an aid to investing.

We have subsequently built our own versions of what he calls ‘the magic formula’ and have found them a worthwhile addition to the criteria we look for in our investments.

Whether you are interested in the technicalities, the broad-based market comments, or simply in hearing a story of success written in a humble and entertaining way, then I highly recommend getting yourself a copy.