I just finished reading renowned investor Joel Greenblatt's latest book - The Big Secret for the Little Investor - on which I have a few comments.
First, this book is quite short and very easy to follow. There are some simple equations explaining financial such as discounted value, but the book is mostly a discussion on basic value principles. Appropriately, Greenblatt quotes Ben Graham and Warren Buffett multiple times. All things considered, the bulk of the book is a pretty solid summary of J.G.'s investing strategies communicated very clearly with all readers in mind.
The Big Secret also serves as a very good introduction to the world of indexes. Greenblatt spends a good portion of the book detailing what indexes are, how they are weighted, their relation to market sentiment, and how their historical returns differ from other passive or 'hands-off' strategies for the small investor - such as mutual funds.
Where I believe this book holds it's true value to the small investor, though, is in the discussion of the illusion that financial models, in all of their complexity, are to be heralded as the crystal ball of the investing world. While it is true that the analysts on The Street are experienced 'professionals' who spend days working on a comprehensive financial model, with multiple spreadsheets linked together and daunting equations, it does not guarantee a more accurate prediction of what this company is worth or more importantly what the market will be willing to pay for it in the future. One reason, Greenblatt notes, is that a more complicated model with more segmented information and forecasting will certainly be more precise, but not necessarily more accurate. Ultimately, any model/valuation that is forecasting future earnings, cash flows etc is making some serious assumptions about what the future will bring. No analyst can predict the price of oil 10 months from now, let alone an earthquake in Japan or widespread political uprising in the Middle East . These things all affect uncertainty which humans naturally associate with fear and thus investment risk, and they are completely unpredictable. Again, precise assumptions don't guarantee accurate ones.
To illustrate the fragile nature of these models, Greenblatt discusses the valuation of a hypothetical company, whereby he changes growth rates by only one or two percent. When forecasted out 10 years, these assumptions can change the 'value' of said company by 80 percent in either direction. Wile Greenblatt himself, I'm sure, uses excel and builds forecasts for future performance, he does not hold this practice to be most important. What he details as most important in investing (as does Buffett) is a thorough understanding of the business, it's industry, and a common sense approach to forecasting growth and market returns. Only then is building a complex model a justifiable use of time and energy.
An investor should therefore be cautious not to purchase any securities on the basis of a buy/sell/hold report coming from their local brokerage. Indeed, the analysts who create these forecasts and price targets are experienced and hard working, but likely this quarter's earnings forecast is just a prefabricated template which has been updated with the most recent financial results. Often, the price target and buy ratings will be adjusted according to the new output of the model. In my view, this is reactionary decision making and will not help keep you one step ahead of the market.
The bottom line is that seemingly comprehensive financial models can be misleading. While they are a great supplement to the investing process, they are by no means primary. An independent investor should take it upon his/her self to read up on the business, understand how it makes money, try to get a grasp on growth prospects, take a look at the financials and - most importantly - make sure it is cheap.
