The Little Book That Beats the Market

1. The Magic Formula: Buy Good Companies at Bargain Prices

Buying good businesses at bargain prices is the secret to making lots of money.

The Magic Formula explained. This simple yet powerful strategy involves two key components:

1. Identifying good businesses: Companies with high returns on capital
2. Finding bargain prices: Stocks with high earnings yields

The formula systematically selects companies that rank high in both categories, essentially finding above-average companies at below-average prices. This approach has historically outperformed the market by a significant margin.

Why it works. The magic formula capitalizes on:

• Market inefficiencies
• Short-term thinking of most investors
• Mr. Market's emotional swings

2. Mr. Market: Your Emotional Business Partner

Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices.

Understanding Mr. Market. Benjamin Graham's concept of Mr. Market helps investors understand stock price volatility:

• Mr. Market is your hypothetical business partner who offers to buy or sell shares daily
• His mood swings wildly, sometimes overly optimistic, other times pessimistic
• These mood swings create opportunities for rational investors

Long-term rationality. While Mr. Market is emotional in the short term, he eventually gets it right:

• Over time, stock prices tend to reflect the true value of businesses
• Patience allows investors to benefit from temporary mispricing
• This concept underpins the success of value investing strategies like the Magic Formula

3. Earnings Yield and Return on Capital: The Two Key Metrics

The magic formula ranks companies based on two factors: return on capital and earnings yield.

Earnings Yield (EBIT/EV):

• Measures how much a company earns relative to its price
• EBIT (Earnings Before Interest and Taxes) / Enterprise Value
• Helps identify undervalued companies

Return on Capital (EBIT / (Net Working Capital + Net Fixed Assets)):

• Measures how efficiently a company uses its capital
• Identifies companies with sustainable competitive advantages
• High return on capital often indicates a "good" business

Why these metrics matter:

• They provide a standardized way to compare companies across different industries
• They account for differences in debt levels and tax rates
• They focus on the core profitability and efficiency of businesses

4. Patience is Key: The Formula Works Over Time

Following the formula for any three-year period in a row, the magic formula beat the market averages 95 percent of the time (160 out of 169 three-year periods tested)!

Short-term underperformance is normal. The magic formula doesn't work all the time:

• Underperforms the market in 5 out of 12 months on average
• Can lag behind for 1-2 years at a time

Long-term outperformance is remarkable:

• Beat the market in 95% of 3-year periods
• Never lost money over any 3-year period in the study
• Achieved superior returns with lower risk than the overall market

Why patience matters:

• Allows time for market inefficiencies to correct
• Smooths out short-term volatility
• Gives the strategy time to prove its effectiveness

5. Diversification: Hold 20-30 Stocks for Best Results

Remember, the magic formula works on average, so holding many stocks that are ranked highly by the magic formula should help keep us close to that average over time.

Optimal portfolio size:

• 20-30 stocks provide sufficient diversification
• Balances concentration and risk management

Benefits of diversification:

• Reduces impact of individual stock volatility
• Increases chances of capturing the "average" return of the strategy
• Protects against unforeseen company-specific risks

Implementation tips:

• Build the portfolio gradually over 9-12 months
• Replace 5-7 stocks every few months as they reach their one-year holding period
• Maintain discipline in following the formula's recommendations

6. The Tooth Fairy Doesn't Exist on Wall Street

On Wall Street, there ain't no tooth fairy!

Harsh realities of investing:

• No one will magically make money appear under your pillow
• Most professional advice and services underperform the market
• You are ultimately responsible for your investment decisions

Common pitfalls to avoid:

• Relying on stockbrokers who are incentivized to sell, not make you money
• Chasing past performance of mutual funds
• Paying high fees for underperforming actively managed funds

Alternatives to consider:

• Index funds for passive, low-cost market exposure
• The Magic Formula for a systematic, evidence-based approach
• Self-directed investing if you have the time, knowledge, and discipline

7. Long-Term Thinking: Stick to the Strategy for 3-5 Years Minimum

Remember, you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work!

The importance of commitment:

• Short-term underperformance is normal and expected
• Long-term results are what matter
• Emotional discipline is crucial for success

Why people fail:

• Lack of patience during periods of underperformance
• Tendency to chase recent winners or popular stocks
• Inability to stick with a strategy that seems to be "not working"

Building conviction:

• Understand the logic behind the Magic Formula
• Study historical results and long-term performance
• Prepare mentally for periods of difficulty

8. Compound Interest: The Eighth Wonder of the World

By contributing just $28,000 in total over the next six years [...] your retirement account could have grown to over $325,000 at the end of 20 years and over $1.3 million after 30 years.

The power of compounding:

• Small, consistent investments can grow dramatically over time
• Higher returns amplify the effect of compounding
• Time is a crucial factor in building wealth

Practical implications:

• Start investing early, even with small amounts
• Maximize contributions to tax-advantaged accounts like IRAs
• Reinvest dividends and capital gains to accelerate growth

Long-term perspective:

• Focus on decades, not months or years
• Understand the exponential nature of compound growth
• Make decisions based on long-term financial goals

9. Give Back: Use Your Success to Make a Difference

I also hope that those investment goals will include using some of your good fortune to make a difference in those areas that are important and have meaning to you.

The importance of giving:

• Financial success creates opportunities to help others
• Giving can provide personal fulfillment and purpose
• Addressing societal issues can have a lasting impact

Potential areas for impact:

• Education reform
• Medical research
• Poverty alleviation
• Social justice initiatives

Thoughtful giving:

• Apply investment principles to charitable efforts
• Look for high "return on capital" in social initiatives
• Consider long-term, systemic changes rather than short-term fixes

Last updated: August 17, 2024