Book Reviews, Valuation, Value Investing

Book Review of The Big Secret for the Small Investor by Joel Greenblatt

I always love reading books by Joel Greenblatt. His books are pretty short and concise which is how I like it, and his first book “You Can Be a Stock Market Genius Even if You’re Not Too Smart” is by far the best book on investments that I have read so far. His 2nd book on his magic formula is also pretty good. His new book is titled “The Big Secret for the Small Investor: A New Route to Long-Term Investment Success”. Needless to say, I quickly got hold of a copy to digest what he has to say.

The website for this book is found here.

Here’s the key points:

  • The secret to successful investing is to figure out the value of something, and then pay a lot less.
  • Valuing a business is tough
    • DCF – Discounted cash flow is very sensitive to slight changes in forecast and input assumptions, and accurate forecasting is tough!
    • Comparables – There aren’t always similar companies, and looking at relative value is dangerous if the entire industry is mispriced (e.g. all internet companies during the dot-com boom were overpriced).
    • Acquisition value – It is not easy to figure out the value of the cost savings + synergies to an acquirer, how much of that will be shared with the acquired company, and whether the business would be willing to sell out even if it generates higher value.
    • Liquidation value – It is difficult to determine how likely it would be for the management of a poorly performing company to liquidate and voluntarily choose to eliminate their own jobs.
  • Basic process of thinking about potential investments
    • Estimate earnings and growth rates.
    • Compare earnings yield against what we could earn risk-free with our money (the minimum risk-free rate to beat is 6%, which is the approximate 10-year U.S. Treasury bond rate).
    • Choose investments where you have high confidence in your estimates and which appears to offer a significantly higher annual return over the long term than the risk-free rate.
    • Compare across other investment alternatives.
    • If you have a hard time estimating future earnings and growth rates, skip the company and find another one. Make your best estimates and comparisons for the handful of companies you can evaluate. Evaluate using all 4 methods (DCF, acquisition value, comparables, liquidation value).
  • To beat the market, play a different game
    • Find bargains from thousands more small companies. Most institutional investors must limit their stakes to 5-10% of the total company, so most don’t bother with companies below $500M or even $1B market cap.
    • Stick to analyzing and investing in a few companies (6-10) where you have special insight or deeper knowledge. Most institutional investors are forced to hold 50-200 positions due to their portfolio size (e.g. no position can be more than 5% of the fund) and their fear of underperforming the market.
    • Look for bargains in special situations that big guys don’t play in, e.g. spinoffs, stocks coming out of bankruptcy, restructurings, merger, liquidations, asset sales, distributions, rights offerings, recapitalizations, options, smaller foreign securities, complex securities, etc. The big guys don’t play because many of these situations involve smaller companies where there is a limited opportunity to invest large sums of capital. They also involve one-off extensive research so few fund managers would choose to spend the necessary time and effort.
  • Idenfiying good fund managers is tough
    • The best performing quartile of fund managers over the deacde spent at least one 3-year period in the bottom half, 79% spent at least 3 years in the bottom quartile, and 47% spent at least 3 years in the bottom 10%.
    • The best performing fund of the last decade earned more than 18% annually, but the average investor in the fund lost 11% annually. This is because the average investor buys the fund after the manager has already outperformed, and pull money out after the manager does poorly. It is hard to put money with good managers that have been recently unsuccessful.
    • A good manager can still underperform the market, despite being able to churn out say 10% consistently at little to no  risk.
  • Why would the market allow us to buy companies at a price that gives us a 15% earnings yield based on last year’s earnings, while others are priced to give only a 5% earnings yield?
    • The market expects earnings to decline or slow going forward for the ex-15% earner, and earnings to grow for the ex-5% earner.
    • My note: If the market is truly efficient, it would mean that the expected future return of each stock, risk-adjusted, is the same.
    • Companies with low expectations are often oversold because of overreaction.
  • Ways of weighting indices
    • Market cap weighted index
      • Owns more of overpriced stocks and less of bargin-priced stocks, the exact opposite of what an investor wants.
      • Turnover of 6-8% per year.
    • Equally weighted index
      • Will have random pricing errors that cancel out over time.
      • Would have outperformed the S&P500 by 1.5-2% per year.
      • Turnover of 16-20% per year.
      • Example: Rydex S&P Equal-weighted ETF (RSP).
    • Fundamentally weighted index
      • Weights each stock using other measures of economic size (e.g. sales, earnings, book value, dividends, etc.). The weighting reflects the economic footprint of the companies rather than the market cap, and hence will be more representative of the overall market and economy.
      • Would have outperfomed the S&P500 by 2% per year since 1962.
      • Turnover of 10-12% per year.
      • Example: PowerShares FTSE RAFI US 1000 Portfolio (PRF).
    • Value index (not value-weighted)
      • Stocks chosen based on value characteristics, e.g. P/E, P/B.
      • After the stocks are chosen, they are weighted by their market capitalization.
      • Example: iShares Russell 1000 Value Index Fund (IWD) chooses ~650 value stocks out of the 1000.
    • Value-weighted index
      • Give more weight to companies that are cheap and good.
      • Cheap is defined by the earnings yield.
      • Good is defined by the return on capital (capital = working capital + fixed assets)
      • Choosing 800-1,000 companies from the largest 1,400 companies to form a value-weighted index, from 1990 to 2010 (6 mths), CAGR is 13.9% vs. Russell 1000’s 7.9% and S&P’s 7.6% (costs of trading and market impact has been modelled).
      • High turnover: Turnover of 80-100% per year.
      • Well diversified: Top 20 stocks account for ~6% of the entire portfolio, compared to the S&P500 where top 20 account for 33%.
      • No small cap effect: 
  • Why does value-weighted index work?
    • Outperformance is due to the value effect of buying companies that appear cheap relative to earnings, cash flows, dividends, book value, and sales.
    • Also due to the fact that the comparison is against a benchmark that is flawed because its market cap-weighted.
    • It is not due to any small cap effect. Over 30 years, there is no significant difference between returns of the Russell 1000 and Russell 2000 indexes. The smallest stock in the Russell 2000 has a ~$150M market cap, meaning small cap effect is for companies even smaller than $150M. The largest 1,400 companies were used for the value-weighted index.
    • A recent paper on the small cap effect is “The Chimera of Small Stock Outperformance” by Edward F. McQuarrie.
  • How to keep your emotions in check
    • Decide on your target exposure to stocks, e.g. 60% of your net worth.
    • You can only invest to a limit of plus/minus 10% (e.g. down to 50% or up to 70%), you cannot exceed the limits even when things go against you or when you want to invest 100% because things are going well.
  • Notes on ETFs
    • ETF holders do not get taxed for trading done by the ETF, and ETFs held for more than a year will receive long-term capital gains treatment.
    • Mutual fund holders get taxed based on the trading of the underlying portfolio.
    • ETFs need to disclose their stock holdings daily. Good active managers will not want to manage an ETF because others can copy too easily.

The book ends with an interesting quote from Benjamin Graham:-

The main point is to have the right general principles and the character to stick to them… The thing that I have been emphasising in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued regardless of the industry and with very little attention to the individual company… Imagine — there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience it seems to stand up under any of the tests that I would make up.

It’s interesting because Graham ended his career with a conclusion that mass diversification with value companies is the way to go, while Buffett learnt that concentration in great businesses is even better.


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