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A New Way to Buy Low and Sell Annually
on 12 January 2006
Ever since computer databases have become more available and computing time and memory have been cheap, anyone can take investment history and devise a "back-tested" solution that would have made you a fortune.
I don't recall any version of such a scheme that ever held up for long when it was then used to make investments going forward. Why? Conditions change.
Mr. Greenblatt's approach uses a 17 year history during one of the strongest bull markets in American investing history to come up with his approach. Will this approach work during a flat or declining market? Who knows?
Mr. Greenblatt argues (unpersuasively to my mind) that his approach will continue to work because the method fails to work very consistently over periods of less than three years. That will discourage anyone from using it for very long.
The approach is summarized on pages 134 and 135. Basically, you go to his Web site and use the data there to pick companies with a low price relative to buy 20-30 stocks over the next year (a few every 3 months). You sell each one a day or so after a year has passed (to get capital gains treatment), and replace it with another stock. You pick a minimum size market cap (he suggests at least $50 million), and you select from among the stocks for companies which traded at the lowest multiple of EBIT (earnings before interest and taxes) which had the highest ration of EBIT to the sum of net working capital plus net fixed assets in the prior 12 months. The Web site does this for you now for free.
Here is another practical problem with the book. You need to have quite a lot of money to start with or trading fees will eat up your capital. Let's say you have $10,000 to start. You will be making 60 trades a year to buy and sell 30 stocks. Assuming you pay on-line commission rates of $10 a trade, that's $600 gone to start. If you pay more for trading the problem is worse. So to be efficient, you will probably have to be able to commit at least $25,000. More is better.
I would have been more impressed if the approach (which is a variation on value investing) had included a search for global value. The U.S. stock market is much more expensive now than many other markets. A bargain in an over-priced market may not be such a bargain after all.
Mr. Greenblatt does have a nice way of explaining his ideas. Any teenager could follow this book. I suggest that the book's best use is in introducing teenagers to the idea that Mr. Market is way too volatile in setting "correct" prices, and you can take advantage of that by buying low. Then hand your teenager a copy of The Intelligent Investor by Benjamin Graham to understand how you can find bargains. If that approach seems too complex for your teenager, provide next a copy of John Bogle's Commonsense on Mutual Funds.