In The Little Book That Beats the Market the author shows an investment strategy he calls the magic formula, which is buying shares of good companies at bargain prices.
I didn't like this book. While it is a quick read and easy to understand, there is so much fluff you could probably leave out half of the book. Also the author sounds like a snake oil seller and that distracts from what he has to say about a sound investment strategy.
After more than 25 years of investing professionally and after 9 years of teaching at an Ivy League business school, I am convinced of at least two things:
- If you really want to "beat the market", most professionals and academics can't help you, and
- That leaves only one real alternative: You must do if yourself.
Actually, just getting started is a big deal. It takes a great amount of discipline to save any money. After all, no matter how much money you earn or receive from others, it's simply much easier and more immediately rewarding to find something to spend it on.
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.
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.
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.
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.
[...] what would happen if we decided to only buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield)?
The magic formula ranks stocks in order. As a result, there should always be plenty of highly ranked stocks to choose from.
The point is that if the magic formula worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain-priced stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. [...] That's why we're so lucky the magic formula isn't that great. It doesn't work all the time. In fact, it might not work for years. 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.
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.
[...] a good track record only helps once you understand why the track record is so good.
When thinking about risk [...] there are really two main things you should want to know about an investment strategy:
- What is the risk of losing money following that strategy over the long term?
- What is the risk that your chosen strategy will perform worse than alternative strategies over the long term?
Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices. Over the long run, it's a completely different story: Mr. Market gets it right.
In short, over time the interaction of all of these things – smart investors searching for bargain opportunities, companies buying back their own shares, and the takeover or possibility of a takeover of an entire company – work together to move share prices toward fair value. Sometimes this process works quickly, and sometimes it can take several years.
Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.
Looking at a whole portfolio of stocks, it turns out that using last year's earnings is often a good indicator of what earnings will look like in the future. Of course, for individual companies, this may not be the case. But on average, last year's earnings will often provide a pretty good estimate for normal earnings going forward.
[...] if we actually use the magic formula, we'll want to own 20 or 30 stocks at one time. In the magic formula's case, we want the average (that is, the average return for a portfolio of stocks chosen by the magic formula).
The more confidence I have in each one of my stock picks, the fewer companies I need to own in my portfolio to feel comfortable.
Most [stockbrokers] get paid a fee to sell you a stock or a bond or some other investment product. They don't get paid to make you money.
Not surprisingly, after subtracting fees and other expenses, the vast majority of mutual funds do not beat the market averages over time.
[...] on average there is no relationship between a fund's good past investment record and its future returns.
In capitalism, if the fixes don't work, the business closes. With public schools, this rarely happens. It's almost impossible to fire bad teachers, pay more for good teachers, or close bad schools. In short, there are no penalties for poor performance, incentives for good performance, or consequences for running a poor business. As a result, money spent on bad teachers or bad schools is almost never redirected to teachers or schools that can achieve higher returns on that capital!
- Use Return on Assets (ROA) as a screening criterion. Set the minimum ROA at 25%.
- From the resulting group of high ROA stocks, screen for those stocks with the lowest Price/Earnings (P/E) ratios.
- 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.
- 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.
- Repeat the previous step every two to three months until you have invested all of the money you have chosen to allocate to your magic formula portfolio.
- Sell each stock after holding it for one year. [...] 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.
- 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!