The Little Book that Beats the Stock Market

Chapter 1

Bubblegum sales business:Earns $500 for next 6 years

What would you pay ? Write down a number.Concept: Time Value of Money or Net Present

Value

A) Competition B) Not as good at SellingC) New Technology- Kids prefer something else

What are the Risks to Buying this Business ?

A) Can you sell more ?B) Can you cut costs ? Sam’sC) Expand Market ?D) New Products ?

Buying Stock is like Buying a Business !

What are Opportunities to Buying this business

Chapter 2

A) Mattress – Pros / Cons ?

And of course Equities/Stock !

Options to Invest $1,000 ?

B) Savings Account Bank-Pros/Cons?C) Corporate Bond –What is a corporate Bond ? Pros/Cons ?D) US Treasury Bond- What is a US Bond Pros/Cons ?

US Treasury Bond - Called “Risk Free” or “No Risk” –

Why ?- Almost 100% Guaranteed- Every Investment Option you

chose should exceed this

Question: If Teddy starts “Gilman Investment Co” and guarantees a return, what should the return at minimum be ?

Chapter 3

Jason’s Gum Business Has Grown !

Decides to Do an IPO (Initial Public Offering), What is the value ? What would you pay ?

JASON's GUM SELLING BUSINESS

$ Sales 10,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 4,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 2,000,000 Taxes (40%) (800,000)Net Income 1,200,000

Corporations / Stock

1) Why form a corporation ?2) IPO:

a)Initial Public Offeringb)Need to be something in Demand-What do you think will be in 2013 ?c) Need Underwriterd) Go on road show-Generate Buzze) Extremely Stressful f) Can make a lot of money-GM: $23.1B, Facebook $104B

2012$685B+90%

IPO – Initial Public Offering-Facebook

- In 2006 Offered $750,000 from Viacomm ?- In 2007 Microsoft buys 1.6% for $240 Million

beating Google (Valuation $15B)- May 18th, 2012 goes public at $38/share worth

$104 Billion- Today what is stock price ?- 40 Lawsuits after the IPO, Botched IPO

2013/14 IPO’s

TwitterDropbox

Priced at $20 11/4/2011Closed at $26 first dayGone down to $5.73

Would you want to work for a start-up ?

What are Pro’s / Con’s to you ? – Stopped 2/25/13PROS

•To see business ideas develop.•To contribute to those ideas and chart a course of action.•Collaboration with creative, enthusiastic professionals.•Changing demands and a flexible, changing schedule.•Greater autonomy and authority.•A quick education in how a business works.•The potential for large financial rewards.

Cons•Lower Salary / Benefits•No Job Description/Unsure how to get things done•Limited Resources•Can be Long Hours•Risk of Losing Job Quickly

2013/14 IPO’s-Forbes Magazine

TwitterDropbox

Priced at $20 11/4/2011Closed at $26 first dayGone down to $5.73

http://www.forbes.com/pictures/eihm45mdmf/spotify-2/

Jason’s Gum Business Has Grown !

Sell 1,000,000 Shares at $12/share.What is Earnings per Share ?What is Rate of Return on Buying 1 share ? Called ?Earnings Yield.

JASON's GUM SELLING BUSINESS

$ Sales 10,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 4,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 2,000,000 Taxes (40%) (800,000)Net Income 1,200,000

1.201.2/12 = 10%

Jason’s Gum Business Has Grown !

Is 10% Acceptable ? WhyWhat would you like to know to make this decision ?

JASON's GUM SELLING BUSINESS

$ Sales 10,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 4,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 2,000,000 Taxes (40%) (800,000)Net Income 1,200,000

Chapter 4

Look At Apple Article:

52 Week High:52 Weeks Low:EPS Changed much ?What is apple worth ?What is Margin of Safety ?

What would you like to know to make this decision ?

Chapter 5

$ Sales 10,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 4,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 2,000,000 Taxes (40%) (800,000)Net Income 1,200,000

Sell 1,000,000 Shares at $12/share.What is Earnings per Share ?What is Earnings Yield on Buying 1 share ?

1.201.2/12 = 10%

Recall Jason’s Gum Selling Business

$ Sales 12,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 6,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 4,000,000 Taxes (40%) (1,600,000)Net Income 2,400,000

Sell 1,000,000 Shares at $12/share.What is Earnings per Share ?What is Earnings Yield on Buying 1 share ?

2.402.4/12 = 20%

Suppose Net Income Rises to:

$ Sales 12,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 6,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 4,000,000 Taxes (40%) (1,600,000)Net Income 2,400,000

So is 2.40 better than 1.2 ? 20% better than 10% ?Does this mean it’s a good company that you should buy ? Why or Why not ?

Suppose Net Income Rises to:

As shares were falling its, Earnings Yield was doing what ? Was it a good buy ?

Look at Blockbuster:- 1994 Bought by Viacomm for $8.4Billion?- 2008 Tries to buy Circuit City1/10/10: Got two quarters? Congrats, you can now buy one share of Blockbuster Inc. (NYSE:BBI), today they finished trading at 50 Cents. Blockbuster's stock fell 31% today, times have changed for the company that still holds the crown as the largest U.S. movie-rental business.

Volume and selling was screaming on Blockbuster shares today 28.5 million BBI shares have traded hands, that's more than 14X the daily average.

$ Sales 12,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 6,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 4,000,000 Taxes (40%) (1,600,000)Net Income 2,400,000

Why do you think Sales grew ?Two Scenarios:a) What if you know that each store Jason opens costs $400,000 and would earn $200,000 per store. Is that good ? What return ?b) If you could invest in another company of comparable risk that costs $400,000 and would earn $100,000 per store, should you ?Called Return on capital Return / Investment. a) 50%, b) 25%

Suppose Net Income Rises to:

2 Main Concepts:

1) Buy Good Companies (High Return on Capital)2) Buy at Bargain Prices (High Earnings Yield)

Chapter 6

Could a company with a top return on capital be ranked lower overall than the 1,500 ranked Company ?

Steps To Take:- Take 3,500 largest companies- Rank 1-3500 on Return on Capital- Rank 1-3500 on Earnings Yield- Add up Rankings for each company, divide by 2

17 Year Period Studied: Magic Formula=30.8%, Market Avg: 12.3%, S&P 12.4%

Chapter 7

Class Agenda / Hope to Accomplish

1) Quiz 9-102) Max Presentation3) Alex Presentation4) Little Book Review 5) Stock Market Game

2 Main Concepts:

1) Buy Good Companies (High Return on Capital)2) Buy at Bargain Prices (High Earnings Yield)

https://personal.vanguard.com/us/funds/vanguard/all?sort=type&sortorder=asc

“The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited.”

Magic Formula works for large companies with establishedEarnings history. Not recommended for Small/Penny Stocks

What is a Penny Stocks ?- Small (In US defined as under $5/share)- Tend to be Thinly Traded- Highly Volatile- Can be manipulated easily. Be careful !

Chapter 8

Issues w/ Magic Formula:- Faired poorly in 5 out of every 12 months- Failed to beat market one out of four years- One out of ever six periods did poorly 2 years in a

row ?

What are your thoughts on these statements ?

BILL MILLER

Questions:a)What happened to Bill Miller in 2007-2009 ? b)Why did he lose ? What investments did not work ?c)Is he a good manager ?

Lessons

1) Unfortunately Everyone Loses – Miller, Buffett, Graham

2) Avoid putting your eggs/investments in One or very few baskets – Financial Sector-Miller

3) We’ll be reading about Mr. Miller again in“The Big Short”

ACTIVE VS. PASSIVE

1) What is an Active Investment Strategy ?

2) What is a Passive Investment Strategy ?

3) 60% - 80% of the time a Passive StrategyBeats an Active Manager ? Should you invest Active?

Why Active ?

1) Manager over time consistently beats index2) As investor believe in certain sector (no index)3) Want to try and beat average-Not content with

average.4) Strategy of manager may fit with overall portfolio

Read Article for Discussion, then Review Morningstar and answer these questions.

ACTIVE VS. PASSIVE

1) Growth or Value / Large Cap or Small Cap ?

3) Has Fund Done well relative to Benchmarks ?

2) How has Fund done last three Years ? What type of market (Bull or Bear) did this fund perform best?

4) Tell me three other things that matter?

Mr. Greenblatt:- Invested with the Smartest Money Manager he knows- Hundreds of Top Investors- Had tough 3-4 years- Only 4 original clients stayed with him- Came back, Top Performing Fund since Inception

Why did people leave ? Why did people leave Mr. Miller ?

What are you going to be ?

Speculator: Try to anticipate and profit from market fluctuations. Sell when things are going down, buy when things are going up ? It can be a drug, feeling great when going up, killing you when coming down.

Investor: Try to acquire and hold suitable securities at suitable prices. Market movements present great opportunities to buy or sell.

Kahneman/Tversky – Pain of a loss is 2 times as great as pleasure of a gain. Losing is so painful, leads to panic and near bottom and not buying more, even when price is great !

March 10th, 2000

Nasdaq hits all time high, Cisco highest market Capitalization. Ralph Acampora says Norfolk Southern or Cisco: Where do you want to be?

Over next year: Cisco lost 70%, Norfolk gained 35%

Graham: The primary cause of failure is that individual investors pay too much attention to what the stock market is doing

Mr. Greenblatt:- People hate to Lose- Investment Horizons tend to be short- Those that look at stocks more often do worse- The magic formula works because it takes

emotion out of it- Everyone gets caught up chasing a winner. Very

dangerous in Bull Markets• All Bull Markets must end and usually badly:

Black Tuesday: 10/29/1929- 13% in 1 day, down 89% next three years

Black Monday: 10/19/1987-23% in 1 day, 2 years to recover

Black Week: Starting 10/6/2008 – 20% down, DJIA High was 14,164 10/9/2007, currently XXXXX down XX%

Tough not to get caught up:Everyone talks about their winners ! Not losers !

Winners draw attention, prices go up, becomes speculative

Leads to constant checking, panic

Paul Andreassan (Harvard/Columbia psychologist) – Investors who received frequent updates on portfolio earned half the returns of

those who did no check at all !

You mess with the Bull, You get

the Horns !

Chapter 9

$ Sales 12,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 6,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 4,000,000 Taxes (40%) (1,600,000)Net Income 2,400,000

Revisit Jason’s Storesa)What if you know that each store Jason opens costs $400,000 and would earn $200,000 per store. Is that good ? What return on capital ?b)What could Jason do with this $2.4M ? c)What would you like him to do ?d)Do you want Dividends ?

Suppose Net Income Rises to:

$ Sales 12,000,000 COGS (Cost of Goods Sold) (6,000,000)Gross Profit 6,000,000 SGA (Selling, General, Admin) (2,000,000)Income Before Taxes 4,000,000 Taxes (40%) (1,600,000)Net Income 2,400,000

What is likely to happen (American Capitalism at work) ?Competiton !a)Less Gum Sold b)Lower prices to attract businessc)Someone builds a better gum shop or gumIn the end, Lower Profits ! Good Businesses attract competition ! Often from inside employees …why

This is a great business: High Return on Capital, High Earnings Yield

Why did Dish buy Blockbuster ?Why did Blockbuster want to buy Circuit City ?Year 2000: I am working at P&G – They are buying Sunny Delight ! Why ? What happened ?Do you think Starbucks maintained the premium coffee market ?Petes, Dunkin Donuts, McDonaldsa)Less Gum Sold b)Lower prices to attract businessc)Someone builds a better gum shop or gumIn the end, Lower Profits ! Good Businesses attract competition ! Often from inside employees …why

Bad/Declining Business could be opportunities

What are some businesses that are new and rising that are being copied?

Frozen Yogurt, Mexican, Made to Order (Panera, Cosi after Subway)

A Rising Business could be opportunity depending on timing:

1)New Products / Constant (R&D)2)Better Products3)Good Brand Name ? Name some4)Strong Competitive Postion – Ebay 1st, Economic Motes

So can be difficult to maintain a High Return on Capital. To do so:

Chapter 10

“The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited.”

1)Why does performance change if solid for number of years ?2)Often Management changes. 1st Question we ask when reviewing managers.

1)Risk of losing money ?2)Risk of not having enough for something important in life: College, Retirement3)Risk of underperforming vs. other options

What is Risk to you when it comes to investing ?

A version of Risk: Boca RatonWealthy Retirement Community-Florida

Author interview retirees: Had they beaten market over lifetime ?

Answer: Some yes, some no,One man: “Who cares, All I know is my investments earned enough for me to end up in Boca”

In the end what matters isn’t crossing the finish line before anybody else but just making sure

you cross it (Reach where you want to go)!

Author will argue correctly:Expected return must equal risk taken !

Rank these options in terms of return expected (write down return you expect):

US Treasury

Internet Startup

Procter & Gamble

Best Buy

Bonds from Greece

Under Armour

Any time you take more risk, you must generate more return !

Moving on: Investment

There is no such thing as a good or bad stock, only cheap stocks and expensive stocks

The best company (ie Apple) becomes a sell when its price gets too high while a bad company is worth buying if its stock gets low enough

Over the Long Term Mr. Market gets it right:Smart Investors jump in when opportunities

present themselves

Companies buy back their own stock (Stock Repurchase) when they think undervalued.

Another Company buys the company whole (agreed or hostile). Usually leads to stock price increase !

Stock Market Game

Chapter 11

How to avoid losing BIG: Diversification

Don’t put your eggs in One Basket ? What does this mean ?

You have 24 eggs to take home for dinner for family, you can carry all in one basket or put 12 in two baskets ? What would you do?

One way to reduce Risk and Limit significant losses: Diversification

Why does a street vendor sell umbrellas and sunglasses ?

Why did Hallmark Cards buy a Spanish TV station ?

Why did Phillip Morris (tobacco company) buy Miller Brewing and Kraft Foods ?

Diversification -Why

1) All three examples: Want to continue to have sales orReturns coming in- ideally constant, limit the significantUps and downs (standard deviation)

2) Investing is the same way. Want to keep investmentsGiving positive returns – If you invest in 1 stock you have a Standard deviation of 40%, you invest in 15 stocks you haveStandard deviation of 10%. Probability of loss w/ 5 StocksIs 23%, with 20 Stocks, 12%

3) Some investments do better when its raining and Some investments do better when its sunny ? Like Weatherman, can’t always predict what is needed !!

You Have a Choice

1) You have $10,000. In Year one you lose 50%. After thatYou make 10%/year for 15 years ?

2) You have $10,000. In Year one you gain 5%. After thatYou make 5%/year for 15 years ?

Year 15 18,987

20,789

Investment 1

You can double the return of investment 2 for 14 years straightAnd still not make up for a significant loss !!!

Investment 2

Should you buy individual Stocks and When ?

Should you buy a lottery ticket ? When ?

Your going to do it. But make sure you are prepared for potential losses.A bit like gambling. Some smart person is buying/selling the opposite.

Chapter 12

You have money to Invest? What will you do / Who will you use ?

- Stockbroker: +Understands markets generally, access to research, - generally paid to sell/fees, good salesman sometimes

- Mutual Fund: + Diversification, - Fees, Active tends to beat passive, good ones attract money, less opportunities

- Hedge Funds: + More Diversification, options, better managers, - Must have lot willing to lose, high fees, best ones get full

- Index Funds: +Lower Fees Mutual Funds, - Average Returns

Chapter 13

Recommendations !

Remember: Importance of Starting Early

Who has more at 65 ? Both $1MHow much did Max put in ? $12,000How much did Aric put in ? $72,000

Max puts $2,000 per year into the market between the ages of 24 and 30 (6 years), that he earned a 12% return, and that he continued to earn 12% per year until he retired at age 65.

Aric also put in $2,000 per year, earned the same return, but waited until he was 30 to start and continued to invest $2,000 per year until he retired at age 65 (36 years).

Give Back- Every one of you receives 25% or $6,250 because of some alumni !

Barbara Dodd Anderson: $128M to George School

Mr. Rollins - $30M to McDonogh: a scholarship student and valedictorian of the class of 1915, became an attorney, businessman, and 27-year McDonogh trustee who repaid the school many times over until his death in 1985.

Mr. Bill Carey: $10M to renovate Carey Hall, Mr Jacobson: $5M to build Lumen Center

Why ? Why does Harvard need more money ($31.7Billion) ?

Gilman gives all of you a chance to attend a good school. Gilman hopefully provides an Education that gives a solid core. Gilman instills traits that will lead to making this country . A better place, a stronger country. Hopefully you appreciate the efforts of past alumni, you want Gilman to be stronger than McDonogh, you hope that by investing in Gilman, the world is somewhat better.

Give Back

Make Money , Reinvest in something that gives back and grows and has meaning to you. Appreciate all that got you to that point ! Right things to do and you will feel good about it !