Book Review: The Little Book that Beats the Market

One of my hobbies is stock market investing. You learn a lot about how businesses work, how the economy works, and you even can make a bit of money if you can keep your head when the market drops.

When I started, I gave myself three years to figure it out. If I didn't do well, I figured I would just buy an index fund and forget about it. With a lot of help from The Motley Fool, I've been able to learn quite a bit. And, it's nice to have a hobby that gives you money rather than takes it away. Not that I have put a lot in yet... and I still have tons to learn.

Anyway, the Motley Fool sent me this book. It was written by an analyst who wanted to explain investing to his kids, and he figured that if he could do that then he could explain it to adults as well.

This is a dangerous activity. The danger is that you could simplify things so much that the kids understand it only because there is no content, and make it inane and boring for the adults; or else you will simply fail, lose both the kids and the adults, and end up saying things that ought not be said, like "but the strike price of an option is obvious!".

This author succeeded, however. This is one of the most interesting investing books I've read. It's very short, and it explains a pretty simple strategy for building a portfolio that consistently beats the market over time. They explain the concepts very well, and very clearly. It was fun just to sit down and read it. Here's a bit of how their system works.

They use two criteria to pick stocks. The first is return on capital. A company that spends $1,000,000 on a store, then earns $500,000 has a 50% return on capital. They sort all the companies based on who has the best ROC, the top one gets a ranking of one, etc.

The second is earnings over price. If a company made $5/share, and a share costs $25, then the E/P ratio is 0.2 (which is actually pretty good). Again, the companies are sorted and ranked.

Then, they take the company's ROC score and add it to the E/P score. Sort again. Out of the 4000+ companies that you run this sort of analysis for, pick a bunch from the top 50 and buy them. What you will have purchased are companies that are able to make lots of money with their business (good performance), and companies that earn a lot of money compared to the price you have to pay for them (good price).

There's a bit more. They spend some time answering the obvious question "if this is so good, why doesn't everybody do it?", and give instructions for how to get started.

I'd say, if you wanted to own stocks in order to get a good return, had a 3-5 year investment horizon, then I highly recommend this book, especially if you don't have much time on your hands to do lots of research. And, if you do want to do further research, then the technique they publish will give you a lot of ideas of companies to investigate.