Today's book is interesting. It is written by a well-known hedge fund manager and value investor Joel Greenblatt. The reason why I find the book so interesting is that it was written in a way for teenagers to understand how to look for value stocks using easily-comprehensible parameters (PE, ROA, ROC).
It is also interesting as the book only focuses on two things - How to know if the business is cheap at the moment and whether the business is a good business. His writings also show that he is a value investor - thinking of stocks as ownership of businesses whose primary objective is to bring in profits for the owners. He also emphasized a lot on this magic formula that would allow you to have above-market-returns.
I love the "Here's what you need to know" section at the end of each chapter. It gives a summary of the key ideas of the chapter, which helps in the writing of this post. Hehehehe. Yes, it is not an easy feat to balance this blog, my work, and my side hustle. If not, usually I would have to include an extensive handwritten portion at the end of each chapter so that I can refer back when I am writing the blog.
Without further ado, here are the lessons that I have learned from the book along with the magic formula that would help you to achieve above-market-returns:
1. Volatility in prices do not make sense - You should not be affected by it:
If you think of your stocks as partial ownership of a business, you should only be worried if the business change. This can be in the form of bad business prospects, reduction in production, or an increase in competition. Hence, when the market quotes us a price on our ownership, we should not be affected by it. Especially when we know the real value of the company that we own.
This is similar to what Benjamin Graham's idea of Mr. Market, where he will give a quotation for your house every day. You would definitely not sell the house if you know that the quotation is lower than the price you know your house is worth.
2. By comparing price and the earnings of the business, you know if the business is cheap:
When we buy into a company, a high price should command higher corresponding earnings. If we buy into an expensive company with a relatively low earnings ratio, it would have a lower growth potential compared to a cheaper company with a relatively higher earnings ratio.
3. By comparing earnings and capital deployed, you can determine if the business is good:
A business that requires a lower capital deployed to achieve a high amount of earnings would mean that the business is highly profitable (hence a good business). This would mean that there is high growth potential, particularly if the business can find ways to generate the same amount of earnings with more capital invested.
4. In the short-term, Mr. Market is crazy. In the long-term, Mr. Market rewards great companies:
Mr. Market is crazy in the short-term as it is an emotional entity. You cannot predict the price that he will quote you for your portfolio in the short-term. But in the long-term, good businesses would be the ones surviving and thriving. This is as they are profitable businesses that have good business prospects.
5. The formula may not work all the time:
In the book, the author has established that the method in the book will not work 1/3 of the time in the back-test. But he promised the readers one thing, by continuing to do it for a long period of time, they would be rewarded with good returns eventually.
The rewards can happen because a) Smart people doing analysis would buy the undervalued stocks would drive the price up b) Profitable businesses can do shares buybacks or dividends c) Profitable businesses are attractive for acquisitions.
"GET ON WITH IT. I WANNA KNOW THE FORMULA" I can hear you shouting behind your screens. Fine.
Formula to find businesses at a good price:
- Price/Earnings ratio
- (EBIT)/(Capitalisation value + interest-bearing debt) - Preferred
Why is the other formula preferred?
EBIT would give us a better understanding of the business' profitability (as different companies would have different interests and tax numbers). The denominator value also takes into account the full amount that the business is valued at (taking into account the capitalization and debt value)
How to determine good business:
- ROA = Net income / Total asset
- EBIT/(Net working capital + Net fixed asset{usually negative due to depriciation}) - Preferred
Why is the other formula preferred?
The denominator would give a better estimation of the operating capital that the business requires to generate the amount of profit.
Step-by-step:
From this 2 formula, we then sort every company in the market (above a certain capitalisation level, eg 500 million), removing financial, utilities and foreign companies. Every 3-4 months, we will buy 5-6 companies that is high on both lists. Then we will get a portfolio of 20-30 stocks that will give us above-market-returns if we do it for more than 3 years
After reading the book, I was really excited to test it out. Hence, I did what I love doing - backtesting data so that I know if the formula would be a reliable way to beat the market.
Backtest:
Instead of relying on the data available in the book, I searched for independent reviews to avoid any biases that the book may have. In the future, when I have the time, I would try to do my own independent backtest as well. But first, let us have a look at it.
Here, we can see that the long-term application of the formula would allow for a 24% rate of return using the magic formula. But in terms of the recent performance, we can see that this value-investing method seems to underperform the benchmark (which is applicable to other value-investing methods as well). From 2005 - 2018, the magic formula has underperformed the market at 5.49% while the market gave a return of 6.2%.Sources:
The little book that beats the market
https://seekingalpha.com/article/4176166-magic-formula-lost-sparkle
https://www.oldschoolvalue.com/investing-strategy/the-magic-formula-investing/
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