The Little Book that Still Beats the Market

A review and summary

I don’t like this books very much. It is too chatty. This kind of attitude, where I feel like an armchair finance, for lack of a better word, Dad makes it his goal to prove to me that he not only understands finance, but can also dumb it all down for me, while also saying the can beat the market… it’s not a good one when your audience is people who seek understanding.

The entire book (before the second edition) is written on the basis of a single dataset, the “Computstat point in time dataset”, whatever that is. Is this really considered suitable evidence? I hope that analysts do more thorough work and back testing than this. I really hope so. Really. I mean, if this passes for professional money managemnt, yikes!

The book makes a lot of odd, seemingly contradictory and unsubstantiated claims. Page 97 claims that only institutional investors can buy large companies’ stocks. Is the claim here that large companies have a larger price per share? This naturally would depend on how many shares are oustanding as well as a company’s market cap. I’m skeptical, to say the least. What’s stranger is that he also claims earlier (I believe) in the book that individual investors should not invest in small market cap stocks either, because this can drive up the price of these stocks; my hunch is that whether or not this is the case depends on the number of stocks of a company oustanding, not its market cap. I really wish he had backed up these arguments. By the way, the book has no citations. Hmm.

There is no reason given whatsoever for the suggestion to buy the top 20-30 stocks ranked by the magic formula, with no weighting whatsoever by how much they vary in earnings yield and return on capital. My hunch is that this is because the author is not great at math. I am used to reading about solving quadratic programming and combinatorial optimization problems to pick optimal asset allocations for one’s goals. (You can read about these kinds of things in Wealthfront’s white papers, which I enjoy because they don’t have as much fluff as this book.)

The author makes untenable claims. For example, on pages 55 and 56, he says that the magic formula has less risk than the overall market, and also higher returns. How he proves it? He redefines risk. I agree that we investors with long time horizons should not consider volatity of returns to be the only risk factor, but this is not an interesting or insightful argument. Anyone can make this argument, regardless of whether financial product they are trying to sell.

One of the key ideas is that a high return on capital is a proxy for a company being in some kind of “good” situation, where good may mean being a monopoly, having a good brand, or so on. In this sense, this investment strategy is always following waves rather than trying to jump on them early. Not good or bad, and not a fault with the book itself. It just is. There are limits to analysis of only a company’s quaterly reports. But realizing that something is a proxy rather than the real thing is an important takwaway for anyone trying to do finance, I think.

The lack of titles for each chapter makes the whole book blend together. Not great for referencing back to specific parts of his arguments.

One of the things which upsets me about the book is that the author claims that, in the time period studied, the magic formula returned an average annual return of 30%. He then claims that, with a 30% annual return, you can earn so-and-so amount of dollars in x years. If only it were that simple. The problem with this argument is that interest if compounding; the amount you earn in one year depends on your starting principle. The author really should have asked his readers this: Suppose that the Magic Formula underperformed the market for many years; would they still want to invest using it? It is an analysis I’d like to do myself (I’m not sue of a way other than Monte Carlo estimates, off the top of my head, unfortunately), and I am disappointed that the author did not do this on his readers’ behalf.

This book reminds me of Millenial Money, since both books make fairly similar arguments about psychology and redefining risk, but the two books are selling different strategies. Nevertheless, I prefer Millenial Money. I feel a much better connection to that book’s author, and I feel like I am not being talked down to.

There’s an endorsement from the Financial Times (a fairly good publication) on the front cover which reads “The best book on the subject in years.” Cleverly, what that particular subject is is left unspecified. I expect that the Financial Times is talking about “Value Investing”. If you’re casually curious about what Warren Buffett is all about, then maybe this book is good for you. Otherwise, pass on it.

TL;DR: If someone promises you magic at the beginning of the book, talks down to you for the rest of the book instead of letting the 2-page description (saved until the very end!) of the magic speak for itself, and does not even explain the magic until two pages at the end, run!