It's called The Little Book that Beats the Market. Measuring five by seven inches and running just 155 pages, it certainly qualifies as little. But does it beat the market?
We wanted to find out.
A little more than a year ago, before the Little Book became a personal-finance bestseller, we decided to put it to the test. Our methodology was straightforward: We used the book's website, magicformulainvesting.com, to generate a list of stocks that met its criteria. Then we opened a portfolio on globeinvestorgold.com using $200,000 (U.S.) of virtual money (we would have used real cash, but The Globe and Mail balked at our request for a hefty raise).
How did we make out? We'll tell you in a moment. First, a quick review of the book's principles.
Written by U.S. hedge fund manager Joel Greenblatt, founder of Gotham Capital, the book lays out a method of value investing that rests on a couple of basic formulas. The best, according to Mr. Greenblatt, are those with a high return on capital and a high earnings yield.
Return on capital (ROC) is defined as pretax operating earnings divided by the sum of net working capital and net fixed assets. The higher the ROC, the more effectively a company is using its capital to generate profit. Earnings yield is calculated by dividing pretax operating earnings by the company's enterprise value -- that is, the sum of its stock and debt. The purpose here is to determine how much profit a company makes relative to what it would cost to buy the business.
Don't let the math scare you. The website has a nifty stock screener that does all the calculations for you; all you do is enter a minimum market capitalization and the number of companies you want. Then, presto, it spits out a list of stocks.
So how did our picks do? Pretty well, actually. For calendar 2006, our portfolio of 20 U.S. stocks posted a gain of 18.2 per cent, beating the Dow Jones industrial average (up 16.3 per cent), the S&P 500 (13.6 per cent) and Canada's benchmark S&P/TSX composite index (14.5 per cent).
Our best-performing stock was casual wear retailer American Eagle Outfitters, which soared 88 per cent. Our timing on this one could not have been better. When we "bought" the stock at the end of 2005, it was sitting in the doghouse after a profit warning. But as results came in above expectations for much of 2006, the stock soared, proving that buying great companies -- American Eagle's sales and earnings are growing at double-digit rates -- at bargain prices is a fine way to make money. (Don't bother with the stock now; it's too expensive.)
Our second-best performer was the floral-delivery company FTD Group, whose stock bloomed by 79 per cent. This was another example of an outfit with a depressed stock that went on to beat earnings expectations. Speculation that FTD may be exploring a possible sale didn't hurt the shares, either.
Takeovers were a big story last year, and our portfolio was no exception. Two of our holdings were taken out: Digital media company InterVideo was snapped up by Corel for $13 a share, and cholesterol drug maker Kos Pharmaceuticals was acquired by Abbott Laboratories for $78 a share. Our gains on InterVideo and Kos were 18 and 61 per cent, respectively.
Is the Little Book perfect? Heck, no. We had a few clunkers, too. Catapult Communications, which makes telecom testing systems, catapulted itself straight into the ground, losing 38 per cent. Other dogs included H&R Block, InfoSpace and King Pharmaceuticals. To be fair to Mr. Greenblatt, it takes time -- sometimes years -- for value stocks to trade at their "true" worth. That's why value investing requires more patience than most people have. It also requires a fair chunk of money to spread risk around adequately. Too bad ours wasn't real.
John Heinzl