Let’s be honest. We all do it. We read a book filled with good advice and then don’t act on any of it, not even to try it out. It’s not because we’re lazy or not smart enough; it’s just that making that leap of faith to act on what we know we should be doing is tough.
But there’s always a moment to start.
This summer, I read “The Big Secret for the Small Investor” by Joel Greenblatt because I wanted to improve my stock selection skills. Greenblatt’s “Big Secret” plan, he concludes that a “Value Weighted Index Fund” (Ratio of Last Year’s Earnings to the working capital and fixed assets on the Company’s balance sheet) will always outperform an “Equally Weighted Index Fund” or “Fundamentally Weighted Index Fund.” This ratio, also known as “Return on Assets (ROA),” shows how efficiently a company is making money with its assets. Benjamin Graham, Warren Buffett’s mentor, supported the idea of buying well below fair value.
Eager to test this strategy, I did the following:
1. I picked five random but reputable companies from different industries.
2. I used money.cnn.com to obtain the necessary balance sheet information for each company.
3. I calculated the relevant ratios.
So, which stock did I choose? Apple (AAPL)!
Why not Colgate-Palmolive, which had the highest ratio? Because you should never choose a stock based solely on one ratio. Even computers that use hundreds of ratios don’t always get it right.
So why did I pick Apple?
1. Who wouldn’t want to own part of a company run by Steve Jobs?
2. Apple products are everywhere and popular in mainstream America.
3. Their products are fantastic, and the Christmas season was approaching.
4. And did I mention Steve Jobs knows how to run a company?
Let’s revisit the comparison between Colgate-Palmolive and Apple:
Apple has $75 billion in cash versus Colgate-Palmolive’s $11.2 billion, and their ratios are close. A company that efficient with that much cash is impressive.
So, I went with Apple.
Three months later – how did I do?
Pretty well! Check out the change in stock price:
Have I become a stock-picking master based on this book and new strategy alone? Absolutely not!
1. Three months is too short a time to declare victory. Any of the other stocks could still perform well.
2. Using this strategy involves both risk mitigation and a bit of luck. Many smart people have spent years trying to find the magic ratios without success. There are countless unquantifiable factors, such as leadership and market perception.
3. It was risky to buy just one stock. What if I had picked the worst performer? Spreading out the risk by buying equal amounts of all the stocks would have given me a 9.5% return but at the cost of higher commissions.
So, for now, I’ll give myself a pat on the back for my pick performing better than expected (and not losing money). Somebody tell Warren Buffett I’m moving up in the world!
