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What Joel would have you consider, in effect, is an index-fund-plus, where the “plus” comes from including in your basket of stocks only good businesses selling at low valuations. And he has an easy way for you to find them.
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: 1. If you really want to “beat the market,” most professionals and academics can’t help you, and 2. That leaves only one real alternative: You must do it yourself.
We have to determine whether we think the business will earn that $1.20 in the coming year—or more than that—or maybe less. Last year’s earnings may be a good starting point for estimating next year’s earnings, but it may not.
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.
Graham referred to this practice of buying shares of a company only when they trade at a large discount to true value as investing with a margin of safety.
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. In effect, the stock market acts very much like a crazy guy named Mr. Market.
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.
Graham’s formula involved purchasing companies whose stock prices were so low that the purchase price was actually lower than the proceeds that would be received from simply shutting down the business and selling off the company’s assets in a fire sale (he called these stocks by various names: bargain issues, net-current-asset stocks, or stocks selling below their net liquidation value).
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
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For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.
In other words, owning a business that has the opportunity to invest some or all of its profits at a very high rate of return can contribute to a very high rate of earnings growth!
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.
Businesses that don’t have anything special going for them (such as new or better products, well-known brand names, or strong competitive positions) are likely to earn only average or below-average returns on capital. If there’s nothing special about a company’s business, then it’s easy for someone to come in and start a competing business. If a business is earning a high return on capital and it’s easy to compete, eventually someone will! They’ll keep competing until returns on capital are driven down to average levels.
feel about investing in the stock market. They may not be particularly good at it, or they may not know whether they are any good at it, but there’s something about the process or the experience that they enjoy. For some of these people, investing by using a magic formula may take away some of that fun. I understand this.
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.
But here’s the thing. If your stockbroker is like the vast majority, he or she has no idea how to help you! Most 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. Of course, while it’s in their interest for you to be successful and many may be fine, well-intentioned professionals, a stockbroker’s main incentive is still to sell you something. They are trained to follow rules, understand certain financial terms, and explain various investment products. As for how to make you money in the stock market or anywhere else, forget
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Mutual fund management companies need to charge a fee for their services. Basic math says that average returns minus fees equals below-average returns.
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.
So I’m usually at a loss. If you want to do as little as possible and you don’t mind doing average, an index fund could be a fine choice. But if you are capable of analyzing businesses and willing to do a fair amount of work, selectively picking individual stocks can be a viable alternative. The only problem is that most people don’t have the time or ability to analyze individual companies. As we discussed last chapter, if you don’t know how to evaluate businesses and project normal earnings several years into the future, you have no business investing in individual stocks in the first place.
For taxable accounts, we will want to adjust that slightly. For individual stocks in which we are showing a loss from our initial purchase price, we will want to sell a few days before our one-year holding period is up. For those stocks with a gain, we will want to sell a day or two after the one-year period is up. In that way, all of our gains will receive the advantages of the lower tax rate afforded to long-term capital gains
To reproduce the results from our tests, we will have to work into our magic formula portfolio over the course of our first year of investing. That means adding 5 to 7 stocks to our portfolio every few months until we reach 20 or 30 stocks in our portfolio. Thereafter, as stocks in our portfolio reach the one-year holding mark, we will replace only the 5 to 7 stocks that have been held for one year.
One screening option was created specifically for this book, magicformulainvesting.com. The magicformula investing.com site is designed to emulate the returns achieved in our study as closely as possible. This site is currently available for free. Step-by-step instructions for selecting stocks using magicformulainvest ing.com follow.
Step 1 Go to magicformulainvesting.com. Step 2 Follow the instructions for choosing company size (e.g., companies with market capitalizations over $50 million, or over $200 million, or over $1 billion, etc.). For most individuals, companies with market capitalizations above $50 million or $100 million should be of sufficient size. Step 3 Follow the instructions to obtain a list of top-ranked magic formula companies. Step 4 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 (for smaller amounts of capital,
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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
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