Author: Greenblatt, Joel
Keywords: value investing, magic formula
Review: 8 / 10
Opinion: the book is written in a plain language, easily understandable boy a teenager with interest in investing. He introduces a "magic formula" that is easy to use and makes buying good companies at bargain prices automatically. A revised edition has been published in 2010, however, i am curious to see how the formula has worked since 2010, during the period when U.S. markets has seen one of the longest bull markets.
“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."
"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."
"Mutual fund management companies get paid based on how much money is invested in each fund. A fund with a successful track record will usually attract more money over time. It is usually in the fund’s economic interest to accept this money. Once a fund grows larger, it may be hard for the manager to continue with the same strategy that led to the successful returns."
"Even professional money managers who believe their strategy will work over the long term have a hard time sticking with it. After a few years of poor performance relative to the market or to their competitors, the vast majority of clients and investors just leave! That’s why it’s hard to stay with a strategy that doesn’t follow along with everyone else’s. As a professional manager, if you do poorly while everyone else is doing well, you run the risk of losing all your clients and possibly your job! Many managers feel the only way to avoid that risk is to invest pretty much the way everyone else does. Often this means owning the most popular companies, usually the ones whose prospects look most promising over the next few quarters or the next year or two."
Other notes:
Magic Formula: invest in companies that have both a high earnings yield and a high return on capital
1) ROC = EBIT/(Net Working Capital + Net Fixed Assets)
2) Earnings Yield: EBIT/Enterprise Value
Data source: compustat's point in time database; use earnings of last 12 months not future estimations, balance sheet most recent figures.
Prefer ROC vs. ROE or ROA because eliminates goodwill factor as well as distortions due to differing tax rates and debt levels.
Prefer enterprise value vs. market cap; because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings.
Exclude utilities, banks, and foreign stocks
"The magic formula portfolio fared poorly relative to the market averages in 5 out of every 12 months tested. For full-year periods, the magic formula failed to beat the market averages once every four years.* For one out of every six periods tested, the magic formula did poorly for more than two years in a row. During those wonderful 17 years for the magic formula, there were even some periods when the formula did worse than the overall market for three years in a row!"
Market cap screening criteria (during 2005)
3500 co's: mkt cap of >50 Mil USD
1000 co's: mkt cap of >100 Mil USD
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."
Don’t buy all 30 stocks at once. Add 5 to 7 stocks to our portfolio every few months until reaching 20 or 30 stocks in our portfolio."
Screening instructions:
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.
Eliminate all foreign companies from the list. In most cases, these will have the suffix “ADR” (for “American Depository Receipt”) after the name of the stock.
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.)
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