The little book that beats the market - still

I've just finished reading the little book that still beats the market, by Joel Greenblatt.  It's written in a very unique and quirky style that resonates well with me.  The magic formula that he documents is a value investing strategy worthy of review.  He very eloquently describes it as "systematically finding above-average companies at below average prices".

The essence of Grenblatt's magic formula is to rank each company by 2 criteria. The first criteria is "quality", for which he uses return on capital, and the second criteria is "cheapness", for which he uses earnings yield.  As point of detail, for return on capital he uses EBIT/(Net Working Capital + Net Fixed Assets), and for earnings yield he uses EBIT/Enterprise Value.




Once each company has a ranking for quality and cheapness, he then creates a combined ranking, such that the cheapest quality companies appear at the top of the list and the expensive dogs appear at the bottom.

Over the course of a year, the top 30 companies are purchased. When each company has been held for a year it is sold (it is sold either just before or after the 12 month period depending on whether a gain or loss needs to be booked for tax purposes) and using an updated list, another "top 30" company is purchased. Presumably, if a company remains in the the top 30 it is not sold, but Joel does not state that.

One of advantages of ranking companies, as opposed to screening companies, is that running the same strategy over various sections of the ranked list becomes possible.   In one experiment, the list was segregated in 10 equals groups (deciles), and each decile was used as input to the investing strategy. The (annualized returns) results based on 21 years data (1988-2009) are tabled below. Rather compellingly, the rankings appear to produce results where each decile performed better than the one below, suggesting a strong correlation between the initial rankings and the stock performance.

Group 1 (Top 10%)	15.2%
Group 2 (Next 10%)	12.7
Group 3 "	12.1
Group 4 "	11.5
Group 5 "	10.7
Group 6 "	10.2
Group 7 "	8.8
Group 8 "	7.1
Group 9 "	4.1
Group 10 (Bottom 10%)	(0.2)

His updated results through to 2009, using the the strict "top 30" companies out of the largest 3,500 companies in the US stock market is 23.8%.

I hope to further analyze Joel Greenblatt's little book that beats the market "magic formula" shortly. 

All in all, the book is well worth a read, and belongs on every value investors bookshelf.  Now, on to my next book -  The Evil Princes of Martin Place

Follow up: Beating the little book...