I just read this interesting book, “The Little Book that Beats the Market“, by Joel Greenblatt. At first, I thought it is just some casual book that I can finish in a while. I was wrong! It contain valuable information in a concise manner. Short and sweet.
Joel Greenblatt is a fundamental investor and he has designed a system to invest in stocks that consistently beat the market averages which he terms as “magic formula”. Now, many of you would be skeptical – how can there be a magic formula? If only life is so simple. True, the magic formula rules are simple but they sound pretty reasonable and logical. But it is the application that is difficult. You shall judge for yourself:
The magic formula is about “buying good companies at bargain prices.” There are only 2 criteria to buy stocks.
#1 Buy companies that are able to get high return on their capital
The primary purpose of businesses and companies is to maximise the returns of their working capital. Business owners must know how to deploy their funds effectively. Hence, it makes sense to buy stocks of companies that can make the most profits with the least amount of capital.
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Quote from the book, “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.”
#2 Buy stocks at bargain prices
Greenblatt mentioned about Benjamin Graham’s concept of “Mr Market”. He opined that “Mr Market” is irrational in the short term, but in the long run, he actually values stocks close to their true value. Hence, there are times to exploit Mr Market’s unstable emotions, that is to buy from him when he is depressed about the stocks. In this way, you can buy the best companies at a low price.
Quote from the book, “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.”
Next, you will rank the companies of #1 and #2. And thereafter, you sum the ranks together. For example, Company ABC is ranked 5th for #1 and ranked 1st for #2, it would have a combined ranking of 6 (5+1). You will then have a ranking table that take into the consideration of the”good companies at bargain prices”.
Focus on the top 30 companies in the table.
How did the magic formula fare?
The results for maintaining the top 30 stocks for 17 years is shown in the table (extracted from the book):
That being said, the magic formula has a caveat in order for it to work. You need to do it for at least 3 years! Quote: “In fact, on average, in five months out of each year, the magic formula portfolio does worse than the overall market. But forget months. Often, the magic formula doesn’t work for a full year or even more.” “Though the process doesn’t always work quickly, two to three years is usually enough time for Mr. Market to get things right.” “Most people just won’t wait that long. Their investment time horizon is too short. If a strategy works in the long run (meaning it sometimes takes three, four, or even five years to show its stuff), most people won’t stick with it. After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy— usually one that has done well over the past few years.”
It may sound easy, “buy the best companies at bargain prices”. How do you do it? Being a responsible person, Greenblatt did state the imperfections of the system. Firstly, it leverage on the average performance of a basket of stocks. If you buy only 1 or 2 stocks of the top 30 stocks, your risk will be higher. And you would need a substantial capital to maintain 30 stocks at one time. Secondly, it is difficult to predict the profitability of the companies in the future. No one, or even the professionals are able to determine that. The best way is to based on past results but the key is to eliminate extraordinary items from the it to normalise the earnings. If you do not know how to do so, you may get inaccurate ranking of the companies.
To make it simple, he has a stock screener at Magic Formula Investing. It’s free but it’s only for US stocks.
The actual formula
This is how Greenblatt determine the 2 criteria:
- Return on Capital = (pre-tax operating earnings)/(tangible assets employed or Net Working Capital + Net Fixed Assets)
- Earnings Yield = (pre-tax operating earnings)/(enterprise value = market value of equity* + net interest-bearing debt) *including preference shares
Do some testing and see if it works!