Book summary: ‘The big secret for the small investor’ by Joel Greenblatt

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 succesful 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 earning, 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 government bond, for which we assume the interest is at least 6%. The interest rate on a 10-year US government bond, we call the risk-free rate. If the earnings yield (earnings/price) of a stock is much higher than the risk-free rate, then it might be a good investment depending on how certain we are of our estimates of future earnings of the company. If the first hurdle is passed, we can compare the attractiveness of investing on stock A to different stocks. If we can’t make an estimate of future earnings of a company, we just skip that investment.

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 underperform 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 overweighted it becomes (and vice-versa). So you end up systematically owning too much of the companies that are overvalued 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 underperform 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 underperformance are a curse, because they will be tempted to abandon their strategy much too soo 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.