This is a little blog post that summarises the key concepts from the book, The Little Book that Beats the Market by Joel Greenblatt
If you really want to “beat the market,” most professionals and academics can’t help you. That leaves only one real alternative: You must do it yourself.You can stick your money under the mattress. (But that plan kind of stinks.)
You can put your money in the bank or buy bonds from the U.S. government. You will be guaranteed an interest rate and your money back with no risk 99.9% of the time.
You can buy bonds sold by companies or other groups. You will be promised higher interest rates than you could get by putting your money in the bank or by buying government bonds—but you could lose some or all of your money, so you better get paid enough for taking the risk.You can do something else with your money.
The 10-year U.S. government bond rate is substantially lower than 6 percent. However, whenever the long-term government bond is paying less than 6 percent, we will still assume the rate is 6 percent. In other words, our other investment alternatives will, at a minimum, still have to beat 6 percent, no matter how low long-term U.S. government bond interest rates go. The big picture is that we want to make sure we earn a lot more from our other investments than we could earn without taking any risk. Obviously, if long-term U.S. government bond rates rose to 7 percent or higher, we would use 7 percent or that higher number.
Buying a share in a business means you are purchasing a portion (or percentage interest) of that business. You are then entitled to a portion of that business’s future earnings.
Figuring out what a business is worth involves estimating (okay, guessing) how much the business will earn in the future.
The earnings from your share of the profits must give you more money than you would receive by placing that same amount of money in a risk-free 10-year U.S. government bond. (We set 6 percent as your absolute minimum annual return when government bond rates fall below 6 percent)
Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period. In effect, the stock market acts very much like a crazy guy named Mr. Market.
It is a good idea to buy shares of a company at a big discount to your estimated value of those shares. Buying shares at a large discount to value will provide you with a large margin of safety and lead to safe and consistently profitable investments.
From what we’ve learned so far, you wouldn’t know a bargain-priced stock if it hit you in the head.
Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.
Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low
return on capital.
Combining the above two points, buying good businesses at bargain prices is the secret to making lots of money. This is the magic formula.
The magic formula works for companies both large and small. The magic formula was extensively tested. The great returns do not appear to be a matter of luck. The magic formula ranks stocks in order. As a result, there should always be plenty of highly ranked stocks to choose from. The magic formula has been an incredibly accurate indicator of how a group of stocks will perform in the future.
The magic formula appears to work very well over the long term. The magic formula often doesn’t work for several years in a row.Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row.For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.
Most people and businesses can’t find investments that will earn very high rates of return. A company that can earn a high return on capital is therefore very special.Companies that earn a high return on capital may also have the opportunity to invest some or all of their profits at a high rate of return. This opportunity is very valuable. It can contribute to a high rate of earnings growth. Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.
By eliminating companies that earn ordinary or poor returns on capital, the magic formula starts with a group of companies that have a high return on capital. It then tries to buy these above-average companies at below-average prices.
Since the magic formula makes overwhelming sense, we should be able to stick with it during good times and bad.
The magic formula works.The magic formula achieved its far superior results with far less risk than the market averages.Although over the short term Mr. Market may price stocks based on emotion, over the long term Mr. Market prices stocks based on their value.
Most people have no business investing in individual stocks on their own.But if you must . . and you can actually predict normalized earnings several years down the road, use
those estimates to figure out earnings yield and return on capital. Then, use the principles of the magic formula to look for good companies at bargain prices based on your estimates of normal earnings.
If you truly understand the business that you own and have a high degree of confidence in your normalized earnings estimates, owning five to eight bargain-priced stocks in different industries can be a safe and effective investment strategy. But most people have no business investing in individual stocks on their own!
Your step-by-step instructions for beating the market using the magic formula are found below.
Step 1: Go to magicformulainvesting.com.
Step 2:Follow the instructions for choosing company size (e.g.,companies with market capitalizations over $50 million,or over $200 million, or over $1 billion, etc.). For most
individuals, companies with market capitalizations above$50 million or $100 million should be of sufficient size.
Step 3:Follow the instructions to obtain a list of top-ranked magic formula companies.
Step 4: Buy five to seven top-ranked companies. To start, invest only 20 to 33 percent of the money you intend to invest during the first year (for smaller amounts of capital, lowerpriced Web brokers.)
Step 5: Repeat Step 4 every two to three months until you have invested all of the money you have chosen to allocate to your magic formula portfolio. After 9 or 10 months, this should result in a portfolio of 20 to 30 stocks (e.g., seven stocks every three months, five or six stocks every two months).
Step 6: Sell each stock after holding it for one year. For taxable accounts, sell winners after holding them a few days more than one year and sell losers after holding them a few days less than one year (as previously described). Use the proceeds from any sale and any additional investment money to replace the sold companies with an equal number of
new magic formula selections (Step 4)
Step 7: Continue this process for many years. 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!
Option 2: General Screening Instructions
If using any screening option other than magicformula investing.com, you should take the following steps to best approximate the results of the magic formula:
• Use Return on Assets (ROA) as a screening criterion. Set the minimum ROA at 25%. (This will take the place of return on capital from the magic formula study.)
• From the resulting group of high ROA stocks, screen for those stocks with the lowest Price/Earning (P/E) ratios. (This will take the place of earnings yield from the magic formula study.)
• Eliminate all utilities and financial stocks (i.e., mutual funds, banks and insurance companies) from the list.
• If a stock has a very low P/E ratio, say 5 or less, that may indicate that the previous year or the data being used are unusual in some way. You may want to eliminate
these stocks from your list. You may also want to eliminate any company that has announced earnings in the last week. (This should help minimize the
incidence of incorrect or untimely data.)
• After obtaining your list, follow steps 4 and 7.
To utilize the magic formula strategy successfully, you must understand only two basic concepts. First, buying good companies at bargain prices makes sense. On average, this is what the magic formula does. Second, it can take Mr. Market several years to recognize a bargain. Therefore, the magic formula strategy requires patience.