30 key points from “The big secret for the small investor”

I have summarised 30 key points from the wonderful book ” The big secret for the small investor by Joel Greenblatt” here-

  1. The secret to successful investing is to figure out the value of something and then pay a lot less.
  2. The value of a business is equal to the sum of all the earnings we expect to collect from that business over its lifetime(discounted back to a value in today’s dollars). Earnings over the next twenty or thirty years are where most of this value come from. Earnings from the next quarter or the next year represent only a tiny portion of this value.
  3. The calculation of value in #2 above is based on guesses. Small changes in our guesses about future earnings over the next thirty plus years will result in wildly different estimates of value for our business. Small changes in our guesses about the proper rate to discount those earnings back into today’s dollars will also result in wildly different estimates of value for our business. Small changes in both will drive us crazy.
  4. If our estimate of value can change dramatically with even small changes in our guesses about the proper earnings growth rate to use or the proper discount rate, how meaningful can the estimates of value made by experts really be?
  5. The answer to the above is- not very.
  6. Figuring out how to value the next thirty plus years of estimated earnings for a company is not the only method investors can use to value a company.
  7. Other methods, such as relative value, acquisition value, liquidation value, and something called sum-of-parts, can also be used to help calculate a fair value.
  8. Unfortunately, all of these methods are difficult to use and can often lead to seriously inaccurate estimates of value.
  9. Once again, if we don’t know how to value a business, we can’t invest in it intelligently.
  10. It is hard to make earnings estimates for the next thirty plus years. It is hard to figure out what those earnings are worth today. So we don’t.
  11. Instead when we evaluate the purchase price of a company, we make sure that our investment will return more than the 6% per year we could earn risk-free from the US government(10 year or 30 year bond). 6% is the minimum. If we can earn higher returns risk-free from a 10 year or 30 year US government bond, we will use that higher rate. Sometimes we might invest in a company that earns less than 6% or the 10 year rate on the government bond. This is because we are confident that the earnings are going to continue to increase significantly and ultimately we will earn more than the 6% rate.
  12. If our investment appears to offer a significantly higher annual return over the long term than the risk free rate and we have high confidence in our estimates, we’ve passed the first hurdle.
  13. Next we compare the expected annual returns of our potential investment and our level of confidence in those returns to other investment alternatives.
  14. If we can’t make a good estimate of the future earnings for a particular company, we skip that one and find a company we can evaluate.
  15. It is really hard for investment professionals to make estimates and comparisons for dozens and sometimes hundreds of companies.
  16. In the stock market there are plenty of ways for investors willing to do some work to gain an edge. Like portfolio concentration( if you can analyse really well), special situations, spinoffs, bankruptcies, restructurings, mergers, liquidations, asset sales, distributions, rights offerings, recapitalisations, options, smaller foreign securities, complex securities,etc.
  17. Most professional managers don’t or can’t take advantage of them.
  18. Given how the system operates, it is very hard for active mutual fund managers to beat the market. This is because of fees and expenses, need to hold many stocks( because of regulation, fear of losing), constrained by style( large cap funds cannot invest in small cap stocks), etc.
  19. Given how both professional and individual investors operate, it’s very hard for them to stick with even the best managers. Winning strategies, by definition must deviate from the market indexes. As a result, almost all good managers go through extended periods of underperformance. Almost all investors run away from managers who underperform.
  20. By the time we figure out who the best managers are, their funds have usually accumulated a large amount of assets under management, making it much more difficult for them to continue with the strategy that made them successful in the first place.
  21. Best managers need not necessarily beat the index, but will beat the risk free rate and the rate of return they achieve is less risky than the market return. The ability to find this beforehand is extremely rare.
  22. Over time, most professional managers can’t beat market capitalisation weighted indexes such as the S&P 500 or the Russell 1000.
  23. If Mr. Market sometimes prices stocks based on emotion, market capitalisation weighted indexes ( weighting based on market cap-turnover 6-8%)will systematically buy too much of the over priced stocks and too little of the bargain priced stocks.
  24. Equally weighted  indexes ( turnover 16-20%) depending on how frequently you rebalance)won’t do this.
  25. Fundamentally weighted indexes( weighting based on economic footprint, like earnings, cash flow, book value and dividends-turnover 10-12%) won’t either. Plus they have some practical advantages over equally weighted indexes. WisdomTree and Research Affliates have created fundamental indices.
  26. Value weighted indexes( turnover 80-100%) do even better.Value weighting means weighting the companies based on how cheap they are( P/E , earnings yield(E/P), P/B, P/CF, P/D, P/S,etc). While buying a business at a bargain price is great, buying a good business at a bargain price is even better. Measures of finding good businesses are high ROA, ROIC, etc. We use trailing numbers rather than forward numbers because we cannot predict what the forward numbers will be. So if you weight based on a combination of cheapness and quality, you can do even better. Backtesting between 1990 and 2010 showed a compounded return of 13.9% for the value weighted index (buying 800-100 companies from the largest 1400 companies)as compared to 7.9% for the Russell 2000 and 7.6% for the S&P 500.
  27. The value weighted index is widely diversified, is tilted towards value stocks. The superior performance is not due to a flawed benchmark or the small cap effect.
  28. The big secret is to have the right principles and follow them systematically. Behavioural finance says that we are hardwired from birth to be lousy investors. Our survival instincts make us fear loss much more than we enjoy gain. We run from danger first and ask questions later. We make quick decisions based on limited data, and we weight most heavily what has happened recently. We think we are above average. We are also overconfident. Therefore we trade too much and overestimate our ability to pick good stocks or to find above average managers and we keep making the same mistakes again and again.
  29. Decide on the strategy to choose stocks:
  • Value weighted better than fundamental weighted better than equal weighted better than market cap weighted.
  • Remember that the strategy might under perform in the short run but will outperform in the long run.
  • Decide what percentage of your assets you are going to invest in stocks. This percentage should be decided based upon how much you are willing to lose. If you invest 100%- you could lose upto 50% in the short run, if 50% then 25% loss is possible in the short run.
  • You can increase or decrease it by 10%. Then buy groups of stocks that are undervalued by some criterion. Stick through this for the long haul. That’s it.
  • Although there are a lot of professional investors, they are all focussed on short term performance rather than long term performance(4-5 years). This makes it difficult for them to follow such a strategy. We can do so because we do not need to report to anyone.

30. ETF and mutual fund suggestions

  • Equally weighted ETF: Rydex S&P equally weight ETF
  • Fundamentally weighted ETF: PowerShares FTSE RAFI US 1000
  • Value index ETF:
  1. Ishares Russell 1000 value index fund
  2. Ishares Russell 2000 value index fund
  3. I shares Russell Midcap value index fund
  4. I shares Russell Small  Cap value index fund
  5. Vanguard value ETF
  6. Vanguard Mid cap Value ETF
  7. Vanguard Small cap value ETF
  8. Ishares MSCI EAFE value index fund

 

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