The Little Book That Beats the Market (Little Books. Big Profits 8)

by Joel Greenblatt

How? Well, as you’ll see next chapter, it turns out that if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.

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. 2. 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. 3. Combining points 1 and 2, buying good businesses at bargain prices is the secret to making lots of money.

The formula starts with a list of the largest 3,500 companies available for trading on one of the major U.S. stock exchanges.5 It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500. Similarly, the company that had the 232nd best return on capital would be assigned a rank of 232. Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield. The company with the highest earnings yield is assigned a rank of 1, and the company with the lowest earnings yield receives a rank of 3,500. Likewise, the company with the 153rd highest earnings yield out of our list of 3,500 companies would be assigned a rank of 153. Finally, the formula just combines the rankings. The formula isn’t looking for the company that ranks best on return on capital or the one with the highest earnings yield. Rather, the formula looks for the companies that have the best combination of those two factors. So, a company that best combination oftwo factors. So, a company that ranked 232nd best in return on capital and 153rd highest in earnings yield would receive a combined ranking of 385 (232 + 153). A company that ranked 1st in return on capital but only 1,150th best in earnings yield would receive a combined ranking of...

TABLE 6.1 Magic Formula Results

So now we know two important things about businesses that can earn a high return on capital. First, businesses that can earn a high return on capital may also have the opportunity to invest their profits at very high rates of return. Since most people and businesses can invest their money at only average rates of return, this opportunity is something special. Second, as we just learned, the ability to earn a high return on capital may also contribute to a high rate of earnings growth. Certainly, that’s good news for the companies chosen by the magic formula.

In short, 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.

But, on average, the high-return-on-capital

companies chosen by the magic formula are more likely to have the opportunity to reinvest a portion of their profits at high rates of return. They are more likely to have the ability to achieve high rates of earnings growth. They are also more likely to have some special competitive advantage that will allow them to continue to earn an above-average return on capital. In other words, on average, the magic formula is finding us good companies!

And what does the magic formula do with this group of good companies . . . ? It tries to buy them at bargain prices! The formula chooses only good companies that also have a high earnings yield. A high earnings yield means that the formula will buy only ...

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.

As we already know, the magic formula picks stocks that have both a high earnings yield and a high return on capital. For earnings yield, the formula looks for companies that earn a lot compared to the price we have to pay. For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings. To calculate these ratios, the magic formula doesn’t look at future earnings. That’s too hard. The magic formula uses last year’s earnings.

In fact, often the near-term prospects for the companies selected by the magic formula don’t look so good. In many cases, the outlook for the next year or two is downright ugly. But that’s one reason the magic formula can find companies whose prices seem like bargains. The magic formula uses last year’s earnings. If, instead, estimates for this year’s or next year’s earnings were used, many of the companies selected by the magic formula might not look like such bargains at all!

How can owning just five to eight stocks possibly be a safe strategy? Think of it this way.24 You’re a successful local businessman who has just sold off his business for $1 million. You want to invest that money wisely so that you can safely earn a good return over time. You have the opportunity to reinvest the proceeds from the sale of your business by buying an ownership stake in some of the other businesses in town. You have some understanding of about 30 of those businesses, and your plan is to invest in companies that you understand well, that have a good future, and that are available at a reasonable price. For those companies about which you feel most confident in your ability to make predictions, you project what normal earnings should be several years down the road. You also look for companies that you believe will be able to continue in business for many years and for companies that should have the ability to grow their earnings over time. Then you calculate earnings yield and return on capital based on your estimates for each of those companies. Of course, your goal is to find good businesses that can be purchased at bargain prices. On the basis of your analysis, you select your five favorites and invest $200,000 in each. Does that sound like risky behavior? It would be if you had no idea how to read financial statements or evaluate individual businesses. But if you do have that ability, is buying a stake in your five favorite businesses enough? Would owning a ...

in varying industries would qualify as prudent behavior. At least, that’s the view I take with my investment portfolio. 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 investors view stocks and the construction of stock portfolios differently, however. Somehow, when ownership interests are divided into shares that bounce around with Mr. Market’s moods, individuals and professionals start to think about and measure risk in strange ways. When short-term thinking and overly complicated statistics get involved, owning many companies that you know very little about starts to sound safer than owning stakes in five to eight companies that have good businesses, predictable futures, and bargain prices. In short, for the few who have the ability, knowledge, and time to predict normal earnings and evaluate individual stocks, owning less can actually be more—more profits, more safety . . . and more fun!

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. • 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.) • After obtaining your list, follow steps 4 and 8 from the magicformulainvesting.com instruction page.