Magic Formula Investing – In 3 Steps

Book Review: The Little Book that Beats the Market

What if you heard there was a “Magic Formula” that said you can beat the market.  You were told that the little guy has a chance to outperform stock market analyst and portfolio managers?  No need to just invest in index funds and wait mindlessly while your investment grows (or diminishes).

In his latest piece, The Little Book that Beats the Market author Joel Greenblatt goes through a simple strategy and explains in plain English how to achieve higher returns than average by just running through a formula and adjusting your positions quarterly.   He calls this the “Magic Formula” that would’ve gotten you 30% annual returns from 1988 – 2004.

Before you write-off the “Magic Formula”, let me inform you the person that devised the strategy is the author of You Can Be a Stock Market Genius, a popular and well known investment book.  And even more impressive, he was founder of Gotham Capital that had an annual return of 50 percent from 1985 to 1995.  That’s right, 50 percent.

As a follower of Warren Buffett, I must admit I was skeptical of Greenblatt just from merely the titles of his books, but after reading both I really enjoyed what he had to say.

High Return on Capital

First step: Buy a good business.  A good business has high returns on capital (capital is what you invest, return is what you get).  For example, Business A requires $100,000 of investment capital and makes $50,000 in profits per year.  That’s a 50% return on capital.  Investment B requires the same amount of $100,000, but only makes $2500 per year – a 2.5% return on capital.  While this is a simple metric it quickly helps you determine which businesses are good and which are bad.  It helps show if the business can command higher prices for their products and whether they have a brand they can leverage to create more profits.  Companies in low margin businesses with no brand or competitive moat tend to get riddled with flagging businesses.

Additionally, businesses with high returns on capital tend to mean that management is in the right business and is likely managing the business well.  This “excess” return on capital for good businesses compared to alternative businesses allows flexibility for management to whether storms and return capital to shareholders in the form of stock buybacks and dividends (both highly valuable).

High Earnings Yield

Second step: Buy cheap.  As we saw in Jimmy’s Gumballs example, buying 50% of the company for $3,000 in order to receive $618 in earnings is a worthwhile investment (21% annual return).  However, if Jimmy wanted to sell half of the company for $20,000 what was a great investment now amounts to a measly 3% annual return.

Probably the most widely used shorthand for determining whether a stock is overvalued or undervalued is the P/E ratio – price to earnings ratio.  The lower the P/E, the lower you’re paying for the business and vice versa.

There are many great companies in the world of stocks, but the challenge is finding then at a good price.  One of the biggest mistakes people make when buying a great company is paying a dear price. A great company does not make it a great investment. The quality of the company must correlate with the price you pay.

Magic Formula

The last step: Combine Step 1 (buy a good business) and Step 2 (buy cheap). There are currently 7,000-8,000 publicly traded on the exchanges.  Let’s say you limit yourself to only the 3,500 largest companies in terms of market cap.  Next, rank the 3,500 issues in your “stock universe” from 1 to 3,500 based on return on capital (#1 being the best).  Now do the same for earnings yield.  Finally, add the two numbers and you end up with ranking of the best companies that have high return on capital as well as earnings yield.

A company that’s cheap (high earnings yield), but really low return on capital gets weeded out.  And a company with great returns on capital, but already has the market’s attention and trading for astronomical prices get weeded out.  The formula leaves you with good and cheap companies.

Below is an excerpt from The Little Book that Beats the Market that compares the Magic Formula results to the general market and S&P500:

Magic Formula Returns from 1988 to 2004

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According to Greenblatt’s table, if you would have applied The Magic Formula principal from 1988 – 2004, you have returned 30.8% during that time period while market returned 12%. Honestly, it does sound too good to be true, but at the same time the system – while stupidly simple – makes a lot of sense.

A Few Downsides

  1. While I trust his stats, I haven’t looked into it and cannot verify the results.
  2. Historic returns, while indicative are not conclusive of future returns.  I feel more comfortable buying a stock that I know – see, touch, and feel – like Coke or P&G.  The strict formulaic approach buying whatever the “system” tells me to still does not sit well with me.
  3. This requires you to monitor your positions and make quarterly adjustments or “re-balancing”.  Greenblatt rightly suggests you can mitigate taxes by waiting to sell your wins for a year to get long-term capital gains.  And if losses, selling them before the one year mark to get short-term capital losses and current year deductions.  While this mitigates your tax obligation, it doesn’t compare to the tax advantages buying and holding a stock indefinitely.  Even if you pay 15% long-term capital gains (more favorable than short-term capital gains rates typically taxed at ordinary income rates), you’re still remitting 15% back to the government annually.  Alternatively, if you can hold a stock for 30 years and ride the wave (hopefully upward), instead of remitting 15% of your gains annually, you can let that “taxable amount” compound (since you don’t pay the government until you sell, although Obama might change this).  Essentially, you get to invest borrowed money from the government interest free.
  4. If this did work and everyone started following it, it would be self-defeating.

In conclusion, I like the simplicity of buying good businesses on the cheap.  You can’t go wrong with that.  However, as an active investor, this should be a starting point not the ending point.  Over time if you wish to beat the market you need to understand what the company does before investing in it; understand the industry; read the financials; and believe the company has a durable competitive advantage.

By |2018-11-11T01:55:34+00:00June 11th, 2010|Estate Planning, Financial Planning, Investments, Trust Planning|