• The Little Book That Beats the Market by Joel Greenblatt (*)
• The Little Book of Bull Moves in Bear Markets by Peter Schiff (***)
• The Little Book of Value Investing by Christopher Browne (****)
• The Little Book of Common Sense Investing by John Bogle (*****)
• The Little Book That Makes You Rich by Louis Navellier (*)

This book, The Little Book That Builds Wealth, is written by Pat Dorsey. Mr. Dorsey is Director of Equity Research at Morningstar. He’s in charge of Morningstar’s equity ratings. In addition to rating mutual funds with one to five stars, Morningstar also rates individual stocks on the same scale.

If the book can be condensed into one word, it’s “moat.” The concept of moat is said to have come from Warren Buffett. It means structural competitive advantages a company holds over its rivals. Warren Buffett mentioned the moat concept as early as more than 20 years ago in his 1986 letter to shareholders:

“The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise.”

This book says that, all else being equal, companies having wide moats will deliver higher returns to investors than companies having no moats or narrow moats. The investing strategy therefore comes in three steps:

1. Find companies with wide moats
2. Buy the stocks at or below their intrinsic values
3. Sell when a company’s moat erodes or when its stock price exceeds the intrinsic value

The book explains what factors contribute to moats and what look like moats but are really not moats. According to Mr. Dorsey, moats are made up of:

• Intangible assets: brands, patents, regulatory licenses
• High customer switching costs
• Benefits from network economics
• Cost advantages: process, location, scale, or access to a unique asset

On the other hand, great products, great size, great execution, and great management are not moats. The book includes many examples for how each of the factors above gives a company moat. It’s written in language that’s both engaging and easy to understand.

Moats are not everything. Valuation also matters. The last 20% of the book touches on the intrinsic value of a company. It introduces the valuation metrics: price to sale, price to book, price to earnings, price to cash flow, and dividend yield. Not much new there. The Little Book of Value Investing by Christopher Browne has more materials in this area.

I don’t invest in individual stocks. I wrote Picking Stocks Is a Waste of Time in 2007. If I were to pick stocks though, buying wide moat stocks below intrinsic value makes more sense to me than magic formula, rule #1, or growth investing.

Coincidentally, Morningstar publishes a Morningstar StockInvestor newsletter that uses the “wide moat below intrinsic value” strategy. Unlike the other authors (Greenblatt, Town, and Navellier), Pat Dorsey did not make sales pitch for this Morningstar newsletter in the book. He didn’t mention it at all. I applaud Mr. Dorsey for that. I want to read a book, not a marketing brochure.

According to Morningstar, the two model portfolios in the StockInvestor newsletter (”Tortoise” and “Hare”) returned 34.2% cumulatively since their inception on 6/18/2001 through 6/30/2009 while the S&P 500 returned -11.8% during the same period. Very nice.

The Morningstar StockInvestor newsletter costs $120 a year. Compared to other newsletters, it’s not exorbitantly expensive. You can see some of the trades in the model portfolios even if you are not a subscriber: example 1, example 2. Using the numbers Morningstar published in its 2008 update (requires free membership), I reconstructed the annual returns for the Tortoise (conservative) and Hare (aggressive) portfolios as follows:

If I were to invest in individual stocks, I would look more into these moat strategies. But I’m not a stock picker and I’m not interested in becoming one. To each their own.

Rating: **** (good).

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The author Louis Navellier is a money manager. He manages mutual funds and wrap accounts with few billion dollars under management. He also publishes four investment newsletters: Blue Chip Growth, Emerging Growth, Quantum Growth, and Global Growth, which cost from a low of $149 a year for Blue Chip Growth, to a high of $5,000 a year each for Quantum Growth and Global Growth. That’s clever marketing if you ask me. Nobody has to subscribe to Quantum Growth and Global Growth. They are there to make Blue Chip Growth look like a great value.

Navellier advocates in this book the strategy of investing in growth companies. He describes how he does it. He evaluates stocks by these eight "tried-and-true key fundamental factors that drive stellar stock price performance":

1. Positive earnings revisions
2. Positive earnings surprises
3. Increasing sales growth
4. Expanding operating margins
5. Strong cash flow
6. Earnings growth
7. Positive earnings momentum
8. High return on equity

He runs screens on these factors for all stocks and he assigns grades (A/B/C/D/F) to each stock. These fundamental factors account for 30% of the overall grade he gives to each stock. The other 70% of the overall grade comes from some quantitative evaluation, which he did not elaborate in the book, other than mentioning "institutional buying power." He then buys stocks with better grades. Perhaps I missed it but I didn’t see much concern about price. That’s a big difference between growth investing and value investing. Value investors often miss the boat on growth companies like Google. They will say it’s a good company but the price is too high. A growth company’s stock price is always too high because it includes anticipation for future growth. While value investors are skeptical, growth investors will let the growth drive the stock price. Navellier explains in this book how each of the eight fundamental factors contributes to the superior growth of a stock.

Growth investing is exciting. Imagine if you catch a Microsoft in the early years. Or even a Krispy Kreme Doughnuts or Crocs while the growth and the anticipation were going strong. Just remember to get out before the growth fades. Not my cup of tea.

There is a lot of self-promotion in this book. Navellier keeps saying how great his picks worked out. I don’t recall any example for how a stock looked good by the eight factors but it crashed and burned. That must have happened. He just doesn’t mention it. Instead, he gives examples for how he was able to detect that a company’s growth was deteriorating and he exited the stock before it crashed. This makes the book read like a marketing brochure.

Navellier also has a companion web site for this book. The companion web site offers a free PortfolioGrader Pro service. If you enter one or more stock symbols, it will give you a grade on each of the eight factors, plus a fundamental grade, a quantitative grade and an overall grade. It won’t give you a list of A- or B-grade stocks. I guess you will have to subscribe to one of his newsletters for that. I entered the stocks in the Dow Jones Industrial Average. Only one stock, Home Depot, received an overall A grade. Four other stocks, IBM, JPMorgan Chase, McDonald’s, and Verizon received B. Others got C and D, with Caterpillar and GE getting an F. If you like speculating on stocks or if you have some legacy positions you are debating whether you should hold or sell, this PortfolioGrader Pro could be useful for getting a second opinion.

Navellier manages these mutual funds:

• Navellier Fundamental A (NFMAX)
• Touchstone Large Cap Growth A (TEQAX)
• Touchstone International Growth A (TAIMX)

Three of his other funds are closing shop. You can research his performance. I didn’t see anything spectacular.

Rating: * (poor). Too much hype and self-promotion. I want to read a book, not a marketing brochure.

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I admire John Bogle. I thought he is the missing name on Forbes 400 List. He’s the founder of The Vanguard Group. Vanguard is best known for its low cost index funds.

John Bogle has always been an advocate for investing in diversified, low cost index funds. The message in this book shouldn’t be a surprise. It makes a great case for keeping it simple and buying index funds that own the entire market. The argument for not paying high expenses on mutual fund management is very compelling. The only reason for paying a high expense would be getting access to managers who beat the market. But there is no guarantee any manager can beat the market. Yes, some managers beat the market in the past, even after the high expenses were taken into account. But you are investing for the future. You don’t have a time machine. Whether any manager is able to beat the market in the future is anybody’s guess. Chances are not good because of high fees, turnover, and taxes. If you pay a high expense, you are paying for a hope, which may or may not be realized. Why gamble?

I really like the story of the Gotrocks in Chapter One, which was first told by Warren Buffett in his 2005 Letter to Shareholders (page 17). The Gotrocks family owned everything until some Helpers arrived and offered some family members the chance to earn more from their investments than other family members. Then the other family members also hired Helpers. The more Helpers they hired, the less all family members earned. The financial intermediaries are exactly like the Helpers. They carve out a piece from the investment returns to themselves, risk free, leaving the rest to investors who took all the risk.

With the Little Book format, Mr. Bogle finally connected with the target audience who need the message the most: the beginner investors. The size of the book is small; the  chapters are short. It’s an easy read. If someone reads this book in the early years of investing, he or she will benefit the most. One can afford to make some mistakes with small investments. Once the size of the portfolio gets large, the mistakes can be very costly.

Besides making the case for investing in index funds, as opposed to investing in actively managed funds, Mr. Bogle also expressed his skepticism toward fundamental indexing and specialized ETFs. I also don’t believe in fundamental indexing, although I do have a few value ETFs. I think some of the sector ETFs, like the often ridiculed HealthShares Cancer ETF, are just crazy. The HealthShares ETFs were eventually liquidated at the end of 2008.

If I have to pick a nit with this book, it’s the “Don’t Take My Words for It” section at the end of each chapter. Here Mr. Bogle quoted other people in support of the arguments presented in the chapter. After identifying the financial intermediaries as croupiers who extract values from investors, he quoted some of the people who work for those croupiers. Even Jim Cramer got a quote. It’s really not necessary. Mr. Bogle’s arguments are already very clear and compelling. He didn’t need Jim Cramer to back him up.

Rating: ***** (Excellent). Recommended for beginner investors and for investors who are still paying too much and receiving too little.

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The author Christopher Browne is a Managing Director of Tweedy, Browne, which is a money management company with $7.6 billion under management as of the end of 2008. Tweedy, Browne boasts its 80-year history and its role as the broker for Benjamin Graham, the father of value investing. It is one of the most well known firms for following the value investing strategy.

The concept of value investing is very simple: buy stocks on sale, with a margin of safety. Its counterpart is growth investing: buy stocks of companies with above-average growth. There is also a hybrid: growth at a reasonable price (GARP). In principle, value investing is intuitive. We all would like to buy stuff on sale as opposed to paying the full price or paying an inflated price. However, the tricky part is figuring out if a stock is really on sale, or what the so-called intrinsic value is. This book explains the tenets of value investing clearly and thoroughly (see table of contents). It tells you how someone following the value investing philosophy looks for values, although it does not prescribe a magic wand as in Rule #1 or Magic Formula Investing. If after reading the book you feel like it’s missing the cookbook recipes for putting what you learned into practice, don’t blame the book. This is a little book, not Security Analysis by Graham and Dodd. Value investing is an art. It requires hard work, experience, courage, patience, and perhaps lack of bad luck. Even the most experienced value managers can’t hit it right all the time. It cannot be reduced to some simple triggers.

I like value investing. My mutual funds portfolio is about 3/4 value, 1/4 growth. I do my value investing through value index funds. I don’t play amateur value manager by analyzing company financial statements. Nor do I buy actively managed value funds. That’s a personal preference. I looked up the performance of some funds managed by well known value managers, including Tweedy, Browne. They have delivered good results.

Rating: **** (good). You will learn something.

Tweedy, Browne also published a white paper What Has Worked In Investing, which makes the case for value investing.

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I picked up this book because I’m interested to see what Mr. Schiff has to say about what one should do in a bear market after he successfully predicted the recession and the bear market. If it delivers what the book’s title says — bull moves in bear markets — everybody should want to know what those moves are. Unfortunately although he correctly predicted the bear market, his recipe for what people should do didn’t turn out too well so far. Maybe those moves will eventually work, but we won’t know until years later. It just shows how difficult it is to make predictions. You can see the recession coming but you can still prescribe the wrong moves. You have to be right in what will happen and in what to do. Being right in one but not the other doesn’t help you make money. Here are a couple of things Mr. Schiff said in this book:

1. There will be hyperinflation in the United States. The U.S. dollar will collapse. Sell U.S. dollar-denominated cash and bonds. Foreign economies will decouple from the U.S. economy. Buy dividend-paying foreign stocks. Instead of hyperinflation, we are having deflation right now. U.S. dollar went up against most major foreign currencies. Foreign equities also dropped 40% or more, not much better or even worse than U.S. stocks. Staying in U.S. dollar cash and bonds would’ve been the correct move.

2. Buy gold and silver. Invest in commodities and stocks of commodity-producing companies. Continuing on the theme of hyperinflation, Mr. Schiff suggested buying commodities including gold and silver, and buying stocks of commodity-producing companies. At the time he wrote this book (July 2008), commodities were at their peak. They collapsed big time since then. Stocks of commodity-producing companies also dropped like a rock. Look at the performance of some funds which invest in commodities and stocks of commodity-producing companies, and compare to S&P 500:

Only gold performed better than S&P 500. Peter Schiff correctly predicted the bear market in U.S. stocks, but moving from S&P 500 to commodities and stocks of commodity producing companies would’ve been a disaster. Maybe commodities will eventually turn around. I added a commodities fund to my portfolio in December 2008, after commodities already collapsed, not when they were at their peak as Mr. Schiff suggested.

I also have problems with the actual implementations recommended in the book. Perhaps the book is targeted at an audience with much higher net worth than the average investor. Even if you believe the predictions, the actual implementations are much more elaborate than what the average investor cares about. According to Mr. Schiff, it’s not enough to buy foreign stocks through a mutual fund or ETF. You have to buy individually selected foreign stocks directly on the foreign stock exchanges. It’s not enough to buy gold or silver through an ETF like GLD or SLV. You’ve got to buy gold bullion, bags of silver coins minted before 1968, or gold certificates issued by Perth Mint in Australia. Of course you need Mr. Schiff’s firm for doing those!

Despite the bad timing and the overly elaborate implementations, the underlying theses presented in the book are not without merit. Whether they will turn out to be true or not is anybody’s guess. Maybe inflation will pick up again. Maybe in the long run the U.S. dollar will depreciate against foreign currencies. Maybe foreign equities will perform better than U.S. equities. Maybe commodities and commodity-producing companies will do better than the rest of the economy. Maybe. Maybe not. Mr. Schiff gave the reasons why he believe they will go that way. He explained his point of view very well. It is a point of view that I don’t want to dismiss out of hand. Others may have different beliefs and equally convincing arguments. I don’t know who will be right. That’s why I diversify between U.S. and international markets including emerging markets. That’s why I invest in Treasury Inflation Protected Securities (TIPS) and commodities.

Rating: ***. You will learn something although don’t bet the farm on it.

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[Update] Here’s a much more detailed rebuttal of what Peter Schiff said in this book, by Mike “Mish” Shedlock of Sitka Pacific: Peter Schiff Was Wrong.

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The author Joel Greenblatt (Wikipedia bio) is a hedge fund manager. In this book he offered a “magic formula” that beats the market, or so he claimed. The underlying principles for the magic formula are very simple:

• Buy good companies
• Pay a bargain price

At first glance, there is nothing wrong with the two principles. All else being equal, everybody wants good companies, not bad ones. All else being equal, everybody would like to pay a bargain price, not an inflated price. But in real life all else are not equal. Good companies are usually not cheap. Cheap companies usually have something wrong with them. The magic formula attempts to solve this problem. It ranks companies by their return on capital (good companies) and earnings yield (bargain price). It then gives you stocks that rank high when both criteria are taken into consideration.

The book has a support site magicformulainvesting.com. It’ll run the formula for you and produce a list of suggested stocks. For the time being, the site is free. You are supposed to buy 5-7 stocks every 2-3 months until you have 20-30 stocks. Then you will re-run the screen. If the first batch of stocks you bought a year ago are not on the list any more, sell them and replace with new stocks on the list. Repeat for each batch around their 1-year anniversary. It is a very concentrated and high turnover strategy. At any time you only have 20-30 stocks and you are replacing 100% of your portfolio every year if the stocks you own fall off the list. Instead, if you buy a total market index mutual fund, you will own thousands of stocks, not just 20 to 30, with very little turnover.

Does it work? Greenblatt said it did over 17 years from 1988 to 2004.

“Over the last 17 years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year.” (p. 52, italics original)

There’s no way to independently verify that record but let’s accept it as accurate. What about the next 17 years? That’s what I’m interested in. I don’t have a time machine which turns the clock back 17 years. And you know what they say about past performance and future performance. As rich as he may be, Greenblatt doesn’t offer any warranty on how the magic formula will turn out in the future. If you have poor results, don’t come crying. He will not make you whole. You are supposed to believe in the formula and stick with it.

“Remember, you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work!” (p. 135, italics original)

What if it didn’t work out even after 5 years? I guess Greenblatt will say you should stick with the formula even longer. Or maybe you will get a “oops, sorry.”

Is this strategy something you can use for your entire portfolio? I don’t think so. Betting everything on 20-30 stocks is very risky. I went to magicformulainvesting.com and got my list of stocks with the minimum market capitalization set at $100 million, as the book recommended. I then run Morningstar’s Instant X-Ray tool on them and here’s what I got:

So basically it wants me to invest 64% of my money in small cap stocks, whereas small cap stocks make up only less than 10% of the U.S. stock market. No way. Can you spell RISKY? Will it beat the market? Maybe, maybe not. I’m not going to wager all my investment dollars on it to find out.

JLP at AllFinancialMatters.com started a simulation on Magic Formula Investing in January 2007. He got good results for the short 6-month period until the last update in early July. But note he is only doing it with hypothetical dollars, not real money. It will also be interesting to see how Magic Formula Investing did in the recent stock market sell-off. If blogger Marsh_Gerda’s experience is typical, it’s not pretty. He had accumulated healthy extra returns over the broad market since February 2006. In three weeks, those extra gains built up in the last 17 months were completely wiped out.

What about doing this only for “play money”? Well, I don’t have “play money.” All my investments are from my hard earned dollars. Why do I want to “play” or gamble with them? Besides, what’s the point of beating the market on only 2% of your investments? How much difference will it make?

Andrew Tobias, who wrote the foreword for Greenblatt’s book, had this succinct statement in his book The Only Investment Guide You’ll Ever Need (review in previous post):

“In the financial marketplace, you get what you pay for, if you are careful. If you try to get more, you get burned.”

That’s something you always have to remember whenever you are attracted to any scheme, no matter what it is. In the end, I guess I’m not that interested in beating the market. If I beat the market, something is wrong. That means I took a bet and the bet came in my favor. But wait a minute, why did I take a bet with my hard earned money in the first place? Gambling is not investing.

Rating: * (avoid).

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