Joel Greenblatt’s opening statements of the book:
- If you really want to “beat the market,” most professionals and academics can’t help you
- That leaves only one real alternative: You must do it yourself
I am assuming we all know the importance of saving money, and there are many ways by which we can keep our money (rather than spending them)
- Keep your savings – let’s say 1000 Rs – in your piggy bank; but after 5 years, that 1000 Rs will be 1000 only, and the giant called inflation will make that 1000 Rs worth less than 1000
- We have banks, who will keep our money, and will pay interest also; so, the bank is a better option than a piggy bank, and it will agree to pay you around 6% compound interest if you put that 1000 Rs for 5 years
- But why lend to banks? We can lend money directly to the companies who offer higher interest payments than banks, but it is not as simple as there is a huge risk of if the company will not be able to pay our money back; we do have another option called “government bond”, which can pay us decent interest rate, with almost no risk; hence, if we are lending money to companies, they have to pay us more than interest on government bond due to risk factor
We often see the price of big and mature companies also keep changing so much during a year, but actually, it doesn’t affect the underlying business
So why do share prices move around so much every year when it seems clear that the values of the underlying businesses do not?
The answer is ‘Who knows and who cares’
Maybe people just go nuts a lot
The truth is that we don’t really have to know why people are willing to buy and sell shares of most companies at wildly different prices over very short periods; we just have to know that they do!
And why we should know that why people do so, because if we are clear about company’s value and its future estimates, that short term prices matter because if we can buy shares at a low price, we can easily act on our valuation and that provides a margin of safety to our investment
Now, we have two points
Company A is there with a share price of 100 Rs
Assume two situations,
- Company has earned 10 Rs profit
- Company has earned 30 Rs profit
In case 1, the company will have an earnings yield of 10% (which is 10 Rs earnings divide by 100 Rs share price)
In another case, the company will have an earnings yield of 30% (which is 30 Rs earnings divide by 100 Rs share price)
Which one do you prefer? Ya, you and I will go for a 30% earnings yield
Higher the earnings yield, the more bargained price you are getting
(The same concept can be taken by Price to Earnings ratio – P/E; for case 1, P/E will be 10, which is share price 100 divide by earnings 10
And it will be 3.33 for case 2;
P/E lower the better; low P/E indicates you are buying a stock at bargained price)
Again, there are two companies, and you have to put your finger on one of them,
Both companies are in the same industry, with the same capital infusion in the business, which is 10,000 Rs
Company A is earning 1,000 Rs every year on a capital investment of 10,000 Rs, which turned out to be a 10% return on investment
Company B is earning 5,000 Rs every year on a capital investment of 10,000 Rs, which turned out to be a 50% return on investment
So, which one do you prefer? Again, it is the most obvious question, you will go for company B
And that’s it. You can become a “stock market master” by only remembering these 2 concepts, it’s too simple, isn’t it?
Believe it or not, you are now a “stock market master”
How? 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
And this is what we call the magic formula!
The magic formula will work only if we believe in it
Application of Magic formula
The magic formula is what we see, that is buying good business (with a high return on capital) at the bargained price (high earning yield)
To apply the formula, we have to take all companies listed on the stock exchange
Then, we have to assign a rank to those companies, based on their return on capital – i.e. we will assign the first rank to the company with the highest return on capital
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 the last rank
Now, we have to combine the ranking, and have to shortlist companies, which are good at both
By doing so, now we have top companies with high return on capital and bargained price; but it is all we should know? Shouldn’t we look at other things? Let’s do it
The first thing we should look at is, from where all those numbers are coming?
Let’s say the formula has shortlisted too small company
Small companies have very few shares available for purchase, and even a small amount of demand for those shares can push share prices higher
If that’s the case, the formula may look great on paper, but in the real world, the fantastic results can’t be replicated
That’s why it’s important that the companies chosen by the magic formula is pretty large
Hence, at the time of application, we have to take companies with decent market capitalization only (although magic formula worker on both large and small companies)
The magic formula can give poor result than the market in short term, but why we to worry about short term!
And if we want accurate return or only good companies, we can spend some time on top companies we found (according to the magic formula), and you can choose 30 companies from top-ranked companies
And that is good for us if the magic formula doesn’t work always!
Yes, it is good for us because, we are going to stay for years with the formula, if someone is following the formula and is not earning returns for few years, he will exit the formula, and that’s what we want
Because if the formula will work all the times, everyone will follow this, and the factor of purchasing companies at the bargained price will ruin away as the price will increase if many people go and buy the same
And again, the Magic formula will work only if we believe in it
Principals behind magic formula must be sensible, logical, and most important, timeless
Similarly, our level of confidence in the magic formula will determine whether we can hang on to a strategy that may be both unpopular and unsuccessful for seemingly long periods
So, what is making sense in the magic formula, which leads us to hold it when things turn against us?
The magic formula helps us finding above-average companies (high return on capital) available at a below-average price (high earning yield); it sounds logical and sensible
The formula gives us companies with a high return on capital, what that means?
Return on capital is how much annual profit a company is making on its total capital invested in the business
High return on capital indicates a company’s business is efficient and the company can earn higher than opportunity cost (govt bond yield) by investing in its own business
But here, one obvious question arises that, why other people won’t come and do same business if the company is earning a too high a return on capital; as competition lead to more options for the customer for the same product and lead to lower the profits for companies
Sometimes, companies introduce new concepts, new products, better products, companies have their brand name or strong competitive position, which make competitors at bay
But companies who don’t have these special bodyguards, generally can’t get a constantly high return
But the magic formula doesn’t choose companies with average returns on capital; It doesn’t choose companies with below-average returns on capital, either; which are the companies who can reinvest in their own business and can earn a high return
And after identifying such companies, the magic formula ranks them according to their earning yield; A high earnings yield means that the formula will buy only those companies that earn a lot compared to the price we are paying
Buying above-average companies at below-average prices, sounds like it should work!
Magic formula beats the market averages in long-term with minimal risk
As the formula gives us companies which are available at a bargained price in the market, how we can say we will be able to sell it at a fair price? What if the price always stays bargained?
Here’s the need for understanding market emotions arriving
- Over the short term, the 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: market gets it right
How the market can do it?
- There are smart people in the market who identifies stocks which are at a bargained price, and they push its price by buying them, and therefore the market gives the fair price in long term
- Even if these so-called “smart” people don’t recognize the bargain opportunity and buy shares, there are other ways that stock prices can move toward fair value
- Companies often buy-back their share; if they feel their shares are undervalued, they purchased their share as it is a good investment; which often leads share price to increase
- Sometimes institutions or company buys all shares outstanding of the company (or buys significant stake in the company), which can lead share price higher
In short, over time the interaction of all of these things work together to move share prices toward fair value
Although over the short term, the market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to the market
The magic formula uses last year’s numbers to build earning yield and return on capital, but how we can know the company will keep booking the same or better number?
One solution is we can take a future estimate of the company to make earning yield and return on capital, but that’s not easy work to do
Well, the answer is that the magic formula doesn’t pick individual stocks, either; It picks many stocks at one time; 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
People who don’t understand the business much, can go with choosing 10 to 30 companies from top companies according to magic formula
But who understands the business, and able to analyze in detail, can go with 5 to 10 companies in different industries
What you can do with your money? Which are the options available?
First, you can go and buy shares of companies available on the stock exchange; but the biggest problem here is which companies to buy
As a solution, we have mutual funds, which are pooled investment vehicle, where we can get a professional allocation of our funds
There are fund managers who manage our money and who know more about the market (professionals); they manage our money for a nominal fee
But mutual funds also are not able to beat the market average in the long run
We have another option called index funds, which will replicate the indexes and will serve market average return minus management fees
We have hedge funds, who have excess to grow money through trading but charge higher management fees
So, an index fund looks attractive, as it can provide a market average return for a long time, which is not bad actually
If you want to beat the market average,
- You have to study companies deeply to forecast their earnings and all that “not easy to do” things
- There is 2nd option, you can use the magic formula, which serves above-average return in the long-term, without making any predictions, without taking too much time
In the end, we need to remember only two points
- First, buying good companies at bargain prices makes sense
- Second, it can take the market several years to recognize a bargain