Well, this is more a note to self than anything. I recently finished The Little Book That Beats the Market. It’s not on the MBA list, but it was an easy read. A well justified diversion.
The basic premise is to buy companies that are undervalued and hold on to them until the market catches up to them. Through a diversification of 20-30 companies, you’ll end up with a much higher return than the market average while mitigating most of the risk.
To validate this, Mr. Greenblatt ran his formula through the market data of the last 17 years. It’s not as long as many other systems have used. CANSLIM in particular has run over 50 years of data. Still, 17 years is pretty good.
It’s not surprising what he found. Buy enough cheap companies and eventually the market will correct the value of those companies, meaning you make money. The trick is finding “cheap” companies and then diversifying enough.
For those of us with less patience and market savvy, he gives a step by step process:
- Go to magicformulainvesting.com
- Choose a low end market cap and get a list
- Buy 5 to 7 of these companies. They are listed in alphebetical order, not by ranking of the formula, so choose among them, not just the top ones.
- Repeat this every two to three months until you own 20 to 30 stocks.
- Hold each stock for a year. (Note: if this isn’t a retirement account, then follow the advice in the book regarding when to sell.)
- Repeat.
The thing that isn’t explicit is how often to refresh the list. Do I get an initial list of 30, then just buy from that list, or every time I buy new stocks, do I generate a new list? I’m guessing generate a new list every time you buy.
The magic formula itself is a simple ranking system. It finds the “cheapest” stocks by looking for stocks with a high return on capital and a high earnings yield.
Return on Capital = EBIT*/(Net Working Capital + Net Fixed Assets)
Earnings Yield = EBIT / Enterprise Value
Each company was ranked by each criteria individually, and then a composite rating was generated from summing the individual rankings. Pretty simple stuff.
Ultimately, a method that beats the market means that it returns on average better yields than the S&P 500 over a period of time. So, what were the returns like for this method?
If you include all stocks of reasonable size, meaning market cap > $50 million, the last 17 years returned an average 30.8%. If you included only the largest 1000 stocks (market cap > $1 billion), to the average return was 22.7%. Not as good, but definitely beats the market.
The real key is longevity. During certain sampling periods the magic formula did indeed return negative results. It still beat the market, but it didn’t always make money. But, if the sampling period was lengthened to 3 years, the magic formula never lost money. It also means that it requires a 3 year commitment.
I’m going to try it. I have a bit of my retirement account set aside, and I plan on starting this April. I’ll keep you updated on the progress of my portfolio.
*Earnings Before Interest and Taxes
