<s> The Little Book
That Beats the MarketJoel Greenblatt
John Wiley & Sons, Inc.
The Little Book
That Beats the Market
The Little Book
That Beats the MarketJoel Greenblatt
John Wiley & Sons, Inc.
Copyright © 2006 by Joel Greenblatt. All rights reservedPublished by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in CanadaNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the1976 United States Copyright Act, without either the prior written permission ofthe Publisher, or authorization through payment of the appropriate per-copy fee tothe Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,(978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requeststo the Publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011,fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author have usedtheir best efforts in preparing this book, they make no representations or warrantieswith respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particularpurpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitablefor your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, orother damages.For general information on our other products and services or for technical support,please contact our Customer Care Department within the United States at (800)762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books. For more informationabout Wiley products, visit our web site at www.wiley.com.ISBN-13 978-0-471-73306-5ISBN-10 0-471-73306-7Printed in the United States of America10 9 8 7 6 5 4 3 2 1
To my wonderful wife, Julie,and our five magnificent spin-offs
Contents
AcknowledgmentsForeword by Andrew TobiasIntroduction
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Chapter OneChapter TwoChapter ThreeChapter FourChapter FiveChapter SixChapter SevenChapter EightChapter NineChapter Ten
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C O N T E N TS
Chapter ElevenChapter TwelveChapter Thirteen
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Step-by-Step InstructionsAppendix
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Acknowledgments
I am grateful to the many friends, colleagues, and familywho have contributed to this project. In particular, specialthanks are due to my partners at Gotham Capital, RobGoldstein and John Petry. Not only are they the truecoauthors of the Magic Formula study that appears in thisbook, but it is also a rare privilege to be associated withsuch brilliant, talented, and generous people. Their contributions to this book—and to the success of GothamCapital—cannot be overstated and are appreciated morethan they know. I would also like to give special thanks toEdward Ramsden at Caburn Capital for his extraordinarilyinsightful comments, suggestions, and editing work; toNorbert Lou at Punchcard Capital, particularly for hisinspiration and suggestions for Chapter 9; and to PatrickEde at Gotham Capital for his major contributions to theMagic Formula study, for his intelligent and helpful
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comments, and for his editing talents. In addition, mybrother, Richard Greenblatt at America Capital, deservesa major part of the credit for being my editor-at-large, forhis many good ideas, for his numerous contributions toeach chapter, and especially for his encouragement withthis project and throughout my life.I am also grateful for the many helpful contributionsand inspiration provided by Dr. Sharon Curhan (my sister,and my favorite artist), Dr. Gary Curhan, Joshua Curhan,Justin Curhan, Linda Greenblatt Gordon at Saddle RockPartners, Michael Gordon, Bryan Binder at Caxton Associates, Dr. Susan Binder, Allan and Mickey Greenblatt(my wonderful parents), Dr. George and Cecile Teebor(the famous in-laws), Ezra Merkin at Gabriel Capital, RodMoskowitz, John Scully, Marc Silbert, David Rabinowitzat Kirkwood Capital, Larry Balaban, Rabbi Label Lam,Eric Rosenfeld at Crescendo Partners, Robert Kushel (mybroker at Smith Barney), Dan Nir at Gracie Capital,Brian Gaines at Springhouse Capital, Bruce Newberg(who got me started), Matthew Newberg, and Rich Pzenaat Pzena Investment Management. Special thanks toDavid Pugh, my editor at John Wiley, and Sandra Dijkstra, my literary agent, for their encouragement andenthusiastic support of this project. Thank you also toAndrew Tobias for graciously writing the foreword andfor being a good friend.
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I would also like to thank my two oldest children,Matthew and Rebecca Greenblatt, for being willing students and readers (and for laughing at most of the jokes).To my three youngest children, thank you for your inspiration. And to all the kids, thank you for the joy you bringeach day. Thank you also to my beautiful wife, Julie, forher sage advice with this book, and in life, for her love andsupport and for each precious day together.
Foreword
The best thing about this book—from which I intend tosteal liberally for the next edition of The Only InvestmentGuide You’ll Ever Need—is that most people won’t believeit. Or, believing it, won’t have the patience to follow itsadvice. That’s good, because the more people who knowabout a good thing, the more expensive that thing ordinarily becomes . . . bye-bye bargain.Yet unlike most “systems” meant to exploit anomaliesin the market, Joel Greenblatt’s simple notion will likelyretain at least a good deal of its validity even if it becomeswidely followed.I don’t want to spoil the surprise—the book is shortenough as it is. My role here is simply to introduce you tothe author, so you have some sense of just how far you cantrust him.
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I’ve known Joel for decades. He is really smart, reallymodest, really well intentioned and—here is the unusualpart—really successful. (I mean: really successful.)More to the point, his success has come from shrewdinvesting (not from selling books).He is also funny. I read the first couple of chapters ofthis book to my 11-year-old nephew, Timmy, and we bothenjoyed it. Timmy, with no investable funds that I knowof, then fell asleep as I raced to the end, mentally rejiggering my retirement plan.Let me tell you this much: In the beginning, therewere mutual funds, and that was good. But their sales feesand expenses were way too high. Then came no-loadfunds, which were better. They eliminated the sales fee,but were still burdened with management fees and withthe tax and transactional burden that comes from activemanagement. Then came “index funds,” which cut fees,taxes, and transaction costs to the bone. Very, very good.What Joel would have you consider, in effect, is anindex-fund-plus, where the “plus” comes from includingin your basket of stocks only good businesses selling at lowvaluations. And he has an easy way for you to find them.Not everyone can beat the averages, of course—bydefinition. But my guess is that patient people who followJoel’s advice will beat them over time. And that if millionsof people should adopt this strategy (Vanguard: please
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hurry up and offer a low-priced fund like this), two thingswill happen. First, the advantage of investing this way willdiminish but not disappear. Second, stock market valuations will become ever so slightly more rational, makingour capital allocation process ever so slightly more efficient.Not bad work for a skinny little book.Now, gather ye what 11-year-olds ye may, and dive in.—Andrew Tobias, author ofThe Only Investment Guide You’ll Ever Need
Introduction
This book was originally inspired by my desire to give eachof my five children a gift. I figured if I could teach themhow to make money for themselves, then I would be givingthem a great gift—truly one that would keep giving. I alsofigured that if I could explain how to make money in termsthat even my kids could understand (the ones already insixth and eighth grades, anyway), then I could pretty muchteach anyone how to be a successful stock market investor.While the concepts covered in this book may seemsimple—perhaps too simple for sophisticated investors—each step along the way is there for a reason. Stay with it,and I assure you the payoff for both beginning and experienced investors will be huge.After more than 25 years of investing professionallyand after 9 years of teaching at an Ivy League businessschool, I am convinced of at least two things:
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1. If you really want to “beat the market,” most professionals and academics can’t help you, and2. That leaves only one real alternative: You must doit yourself.Luckily, that might not be such a bad thing. Asimprobable as it may seem, you can learn to beat themarket. Through a simple, step-by-step process, thisbook can teach you how. To help you along, I haveincluded a magic formula. The formula is simple, itmakes perfect sense, and with it, you can beat the market, the professionals, and the academics by a wide margin. And you can do it with low risk. The formula hasworked for many years and will continue to work evenafter everyone knows it. Although the formula is easy touse and will not take much of your time, it will work foryou only if you make the effort to fully understand why itworks.Along the way, you will learn:• How to view the stock market• Why success eludes almost all individual and pro-
fessional investors• How to find good companies at bargain prices• How you can beat the market all by yourself
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I have included an Appendix section for those of youwith a higher level of financial training, but it is not necessary for people to read or understand the appendixes tobe able to understand and apply the methods found in thisbook. The truth is that you don’t need an MBA to beatthe market. Knowing lots of sophisticated formulas orfinancial terms isn’t what makes the difference. Understanding the simple concepts in this book . . . is.So please enjoy this gift. May the small investment oftime (and 20 bucks or so) greatly enrich your future.Good luck.
Chapter One
J ASON’S IN THE SIXTH GRADE, and he’s making a fortune.My son and I see him almost every day on the way toschool. There’s Jason in the back of his chauffeur-drivenlimousine, all decked out in cool clothes and dark sunglasses. Ahhh, to be 11 years old, rich, and cool. Nowthat’s the life. Okay, maybe I’m getting a little carriedaway. I mean, it’s not really a limousine; it’s kind of ascooter. And the cool clothes and sunglasses part, well,that’s not really true, either. It’s more like his belly hanging over a pair of jeans, no sunglasses, and what he hadfor breakfast still stuck to his face. But that’s not mypoint. Jason’s in business.
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It’s a simple business, but it works. Jason buys gum,four or five packs a day. It’s 25 cents for a pack and fivesticks of gum to a package. According to my son, once inschool, Jason transforms himself into a superhero ofsorts. Neither rain nor sleet nor evil hall monitors cankeep Jason from selling his gum. I guess his customerslike buying from a superhero (or maybe they’re just stuckin school), but however he does it, Jason sells each stickof gum for 25 cents. (Supposedly—I’ve never actuallyseen it myself—Jason kind of shoves an open pack of guminto a potential customer’s face and repeats “You wantsome, you know you want some!” until his fellow studenteither collapses or forks over a quarter.)The way my son has it figured, that’s five sticks at 25cents each, so Jason rakes in $1.25 for each pack he sells.At a cost of 25 cents per pack, that means Jason is making $1 of pure profit on every pack he can shove . . . Imean, sell. At four or five packs a day, that’s a lot ofmoney! So after one of our daily Jason sightings, I askedmy sixth-grader, “Gee, how much do you think this guyJason can make by the end of high school?” My son—we’llcall him Ben (even though his real name is Matt)—startedwhizzing through the calculations using all his brainpower(and a few fingers). “Let’s see,” he replied. “That’s, say,four bucks a day, times five days a week. So, $20 a week,36 weeks of school, that’s $720 a year. If he has six years
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left until he graduates, that’s somewhere over $4,000more he’ll make by the end of high school!”Not wanting to miss an opportunity to teach, I asked,“Ben, if Jason offered to sell you half of his business, howmuch would you pay? In other words, he’ll share half hisprofits from the gum business with you over the six yearsuntil he graduates, but he wants you to give him moneynow. How much would you give him?”“Well . . .”—I could see Ben’s wheels start to turnnow that there might be some real money on the line—“maybe Jason doesn’t sell four or five packs a day, butthree packs—that’s a pretty safe bet. So maybe he makesthree bucks a day. That’s still $15 in a five-day schoolweek. So, 36 weeks in a school year, that’s 36 times 15 (Imight have helped a little in here), that’s over $500 a year.Jason has six more years of school, so 6 times $500 is$3,000 by the time he graduates!”“Okay,” I said, “so I guess you’d pay Jason $1,500for half of those profits, right?”“No way,” Ben answered quickly. “First, why shouldI pay $1,500 to get back $1,500? That doesn’t make anysense. Besides, the $1,500 I get from Jason will take sixyears to collect. Why would I give him $1,500 now to getback $1,500 over six years? Also, maybe Jason does a little better than I figure and I get more than $1,500, but hecould do worse, too!”
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“Yeah,” I chimed in, “maybe other kids start to sellgum in school, and Jason has so much competition hecan’t sell as much.”“Nah, Jason’s practically a superhero,” Ben says. “Idon’t think anyone can sell as well as Jason, so I’m not tooworried about that.”“So I see your point,” I responded. “Jason’s got agood business, but $1,500 is too much to pay for half. Butwhat if Jason offered you half his business for $1? Wouldyou buy it then?”“Of course,” Ben shot back with a “Dad, you’rebeing an idiot” kind of tone.“So, fine,” I said, ignoring the tone for a moment.“The right price is somewhere between $1 and $1,500.Now we’re getting closer, but how much would youpay?”“Four hundred fifty bucks. That’s how much I’d paytoday. If I collected $1,500 over the next six years, I thinkthat would be a good deal,” Ben said, evidently pleasedwith his decision.“Great!” I responded. “Now you finally understandwhat I do for a living.”“Dad, what the heck are you talking about? Now I’mtotally lost. I’ve never seen any gum!”“No, Ben, I don’t sell gum. I spend my time figuringout what businesses are worth, just like we did with
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Jason’s business. If I can buy a business for a lot less thanI think it’s worth, I buy it!”“Wait a second,” blurted out Ben. “That sounds tooeasy. If a business is worth $1,000, why would anyone sellit to you for $500?”Well, as it turned out, Ben’s seemingly reasonableand obvious question was actually the magic question thatgot this whole project started. I told Ben that he had justasked a great question, that believe it or not, there is aplace where they sell businesses at half price all the time.I told him that I could teach him where to look and howto buy those bargains for himself. But, of course, I toldhim there was a catch.The catch isn’t that the answer is incredibly complicated. It’s not. The catch isn’t that you have to be somekind of genius or superspy to find $1,000 bills selling for$500. You don’t. In fact, I decided to write this book so thatBen and his siblings could not only understand what I do fora living but also so that they could learn how to start findingthese bargain investments for themselves. I figure whatevercareer they choose in the future (even if it’s not money management, a career I’m not necessarily encouraging), they’lldefinitely need to learn how to invest some of their earnings.But, like I told Ben, there is a catch. The catch is thatyou have to listen to a long story, you have to take the timeto understand the story, and most important, you have to
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actually believe that the story is true. In fact, the story evenconcludes with a magic formula that can make you richover time. I kid you not. Unfortunately, if you don’tbelieve the magic formula will make you rich, it won’t. Onthe other hand, if you believe the story I’m going to tellyou—I mean really, truly believe—then you can choose tomake money with or without the formula. (The formulawill take significantly less time and effort than doing the“work” yourself, and will provide better results for mostpeople, but you can decide which way to go when you’redone reading.)Okay, I know what you’re thinking. What’s this beliefstuff about? Are we talking about a new religion, maybesomething to do with Peter Pan or The Wizard of Oz? (Iwon’t even bring up the witch-inside-the-crystal-ball thingthat still scares the heck out of me, or the flying monkeys,mainly because neither has anything to do with my story.)And what about the getting rich part, what’s that? Can abook really teach you how to get rich? That doesn’t makesense. If it could, everyone would be rich. That’s especially true for a book that claims to have a magic formula.If everyone knows the magic formula and everyone can’tbe rich, pretty soon the formula will have to stop working.But I told you this was a long story. I’m going to startfrom the very beginning. For my kids and most others,almost all of this stuff will be new. For adults, even if they
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think they know a lot about investing already, even ifthey’ve been to graduate business school, and even if theymanage other people’s money professionally, most havelearned wrong. And they’ve learned wrong from thebeginning. Very few people really believe the story I’mgoing to tell. I know this because if they did—if theyreally, truly did—there would be a lot more successfulinvestors out there. There aren’t. I believe I can teach you(and each of my children) to be one of them. So let’s getstarted.
Chapter Two
ACTUALLY, JUST GETTING STARTED is a big deal. It takes agreat amount of discipline to save any money. After all, nomatter how much money you earn or receive from others,it’s simply much easier and more immediately rewarding tofind something to spend it on. When I was young, I decidedthat all my money should go to Johnson Smith. Of course,I’d love to tell you that Johnson Smith was an orphan whojust needed a little help. I’d love to tell you that the moneygiven to Johnson Smith helped change his life. I’d love totell you that, but it wouldn’t be completely accurate. Yousee, Johnson Smith was a company. Not just any company,either. It was a company that sold whoopee cushions, itching powder, and imitation dog vomit through the mail.
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I mean, I didn’t completely throw away all my money.I did buy some educational stuff, too. Once, the guys atJohnson Smith were able to sell me a weather balloon thatwas 10 feet tall and 30 feet around. I’m not sure what agiant balloon had to do with the weather, but it soundededucational, sort of. Anyway, after my brother and Ifinally figured out how to blow it up by somehow reversing the airflow on the vacuum cleaner, we ran into a bigproblem. The 10-foot balloon was quite a bit larger thanour front door. Using a complicated formula that not evenEinstein could fully comprehend, we decided that if weturned our backs and pushed really hard, the giant balloon could be squeezed out without bursting the balloonor damaging the door (and besides, our mother wasn’thome yet). And it worked, except we forgot one thing.It seems that the air outside was colder than the airinside our house. That meant that we had filled our balloon with warm air. And since, as everyone except apparently me and my brother knew, hot air rises, the balloonstarted to float away. The two of us were left chasing agiant balloon down the street for about half a mile beforeit finally popped on a tree.Luckily, I learned a valuable lesson from the wholeexperience. Although I don’t exactly remember what thatwas, I’m pretty sure it had something to do with theimportance of saving money for things that you might
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want or need in the future rather than wasting money buying giant weather balloons that you get to chase down theblock for all of three or four minutes.But for our purposes, let’s assume that we can all agreethat it is important to save money for the future. Let’s alsoassume that you have been able to resist the many temptations of the Johnson Smith people and the thousands ofother places calling out for your money; that you (or yourparents) have been able to provide for all of the necessitiesof life, including food, clothing, and shelter; and that bybeing careful about how much you spend, you have somehow been able to put aside at least a small amount of money.Your challenge is to put that money—let’s say $1,000—someplace where it can grow to be even more money.Sounds simple enough. Sure, you can just put it underyour mattress or in your piggy bank, but when you cometo get it, even years later, you’ll still be left with the same$1,000 you put there in the first place. It won’t grow atall. In fact, if the prices of the things you were going tobuy with that money go up during the time your moneywas just sitting there (and therefore your $1,000 will buyless stuff than it used to), your money will actually beworth less than it was worth the day you put it away. Inshort, the mattress plan kind of stinks.Plan B has got to be better. And it is. Just take that$1,000 over to the bank. Not only will the bank agree to
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hold your money, they’ll pay you for the privilege. Eachyear, you’ll collect interest from the bank, and in mostcases, the longer you agree to let them hold your money,the higher the interest rate you’ll get. If you agree to keepyour $1,000 with the bank for five years, you might collectsomething like 5 percent in interest payments per year. Sothe first year you collect $50 in interest on your $1,000original deposit, and now you will have $1,050 in the bankat the beginning of year 2. In year 2, you collect another5 percent interest on the new, higher total of $1,050, or$52.50 in interest, and so on through year 5. After fiveyears, your $1,000 will grow into $1,276. Not bad, andcertainly a lot better than the mattress plan.Which brings us to Plan C. This plan is known as “whoneeds the bank?” There’s an easy way to just skip the bankaltogether and lend to businesses or to a group of individuals yourself. Often businesses borrow money directly byselling bonds. The corner bakery won’t usually sell these,but larger (multi-million-dollar) companies, such as McDonald’s, do it all the time. If you purchase a $1,000 bond froma large company, for example, that company might agree topay you 8 percent each year and pay back your original$1,000 after 10 years. That clearly beats the crummy 5 percent the bank was willing to pay you.There’s one little problem, though: If you buy a bondfrom one of these companies and something goes wrong
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with its business, you may never get your interest or yourmoney back. That’s why riskier companies—say, Bob’sHouse of Flapjacks and Pickles—usually have to payhigher interest rates than more solid, established ones.That’s why a company’s bonds have to pay more than thebank. People need to make more money on their bond tomake up for the risk that they may not receive thepromised interest rate or their original money back.Of course, if you’re not comfortable taking any riskof losing your $1,000, the U.S. government sells bonds,too. While there is nothing completely riskless in thisworld, lending money to the U.S. government is the closest any of us will ever get. If you are willing to lend theU.S. government your money for 10 years, the government might, for example, agree to pay you something like6 percent per year (if you lend for shorter periods oftime—say, five years—the rate will usually be lower,maybe 4 or 5 percent).For our purposes, the bond we’ll be looking at most isthe U.S. government bond that matures (pays off theoriginal loan) after 10 years. We’ll be looking at that onebecause 10 years is a long time. We’ll want to comparehow much we can earn from a safe bet like a U.S. government bond with our other long-term investmentchoices. So if the annual interest rate on the 10-year
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government bond is 6 percent, that essentially means thatpeople who are willing to lend their money out for 10years, but are unwilling to take any risk of losing theiroriginal investment or of not receiving the promised interest rate, can still expect to receive 6 percent each year ontheir money. In other words, for people willing to locktheir money up for 10 years, the “no risk” rate of returnis 6 percent per year.It’s important to understand what that means. Itmeans that if anyone asks you to loan them money or toinvest with them over the long term, they better expect topay you more than 6 percent a year. Why? Because youcan get 6 percent a year without taking any risk. All youhave to do is lend money to the U.S. government, andthey’ll guarantee that you receive your 6 percent eachand every year, along with all of your money back after 10years. If Jason wants money for a share of his gum business, that investment better earn you more than 6 percent per year, or no way should you do it! If Jason wantsto borrow money over the long term, same deal. He better expect to pay you a lot more than 6 percent. After all,you can get 6 percent risk free by lending to the U.S.government!And that’s it. There are only a few things you need toremember from this chapter:
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Quick Summary
1. You can stick your money under the mattress. (Butthat plan kind of stinks.)2. You can put your money in the bank or buy bondsfrom the U.S. government. You will be guaranteedan interest rate and your money back with no risk.*3. You can buy bonds sold by companies or othergroups. You will be promised higher interest ratesthan you could get by putting your money in thebank or by buying government bonds—but youcould lose some or all of your money, so you betterget paid enough for taking the risk.4. You can do something else with your money. (We’lltalk about what in the next chapter.)And I almost forgot,5. Hot air rises.Hey, I did learn something from that balloon after all.Thanks, Johnson Smith.*Bank deposits up to $100,000 are guaranteed by an agency of the U.S.government. You must hold your bank deposit or your bond until it matures(possibly 5 or 10 years, depending upon what you buy) to guarantee no lossof your original investment.
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I’m going to make your life even simpler. As I writethis, the 10-year U.S. government bond rate is substantially lower than 6 percent. However, wheneverthe long-term government bond is paying less than 6percent, we will still assume the rate is 6 percent. Inother words, our other investment alternatives will, ata minimum, still have to beat 6 percent, no matterhow low long-term U.S. government bond interestrates go. The big picture is that we want to make surewe earn a lot more from our other investments thanwe could earn without taking any risk. Obviously, iflong-term U.S. government bond rates rose to 7 percent or higher, we would use 7 percent or that highernumber. Now that’s really it.
Chapter Three
OKAY. WHAT ELSE CAN YOU DO with your money? Let’s faceit: Putting money in the bank or lending it to the government is really boring. Hey, I know! Why don’t we just goto the track and bet it all on a horse! Nah, I actually triedthat—didn’t work out too well. I even tried the dog races.That’s where a bunch of greyhound dogs