The Little Book That Still Beats the Market (Little Books. Big Profits 29)

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

Combining points 1 and 2, buying good businesses at bargain prices is the secret to making lots of money.

The magic formula simplified. The magic formula is a systematic approach to investing that combines two key principles: buying good businesses and finding bargain prices. It ranks companies based on their return on capital (indicating business quality) and earnings yield (indicating price). By focusing on these two factors, investors can identify companies that are both profitable and undervalued.

How it works:

• Ranks companies based on return on capital and earnings yield
• Selects top-ranked companies for investment
• Holds positions for one year before re-evaluating

The formula's power lies in its simplicity and logic. By consistently applying these principles, investors can build a portfolio of high-quality companies at attractive prices, potentially leading to superior long-term returns.

2. Understanding Mr. Market's Emotional Swings

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

Exploiting market irrationality. The concept of Mr. Market, introduced by Benjamin Graham, illustrates the stock market's short-term irrationality. This personification helps investors understand that market prices don't always reflect a company's intrinsic value, creating opportunities for savvy investors.

Key aspects of Mr. Market:

• Prone to extreme mood swings, from euphoria to despair
• Offers to buy or sell stocks at varying prices daily
• Provides opportunities to buy low and sell high

Understanding Mr. Market's behavior is crucial for successful investing. It allows investors to remain rational when others are not, potentially leading to better investment decisions and higher returns over time.

3. Return on Capital: The Key to Identifying Good Businesses

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.

Identifying competitive advantages. Return on capital is a crucial metric for assessing business quality. It measures how efficiently a company uses its resources to generate profits. High return on capital often indicates a competitive advantage, which can lead to sustained profitability and growth.

Characteristics of high return on capital businesses:

• Strong brand recognition
• Unique products or services
• Economies of scale
• Network effects
• Patents or proprietary technology

By focusing on companies with high returns on capital, investors can identify businesses with durable competitive advantages. These companies are more likely to maintain their profitability over time, potentially leading to better long-term investment returns.

4. Earnings Yield: Finding Bargain-Priced Stocks

Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less.

Valuing earnings power. Earnings yield is the inverse of the price-to-earnings ratio and represents the percentage of each dollar invested that is earned by the company. A high earnings yield indicates that a stock is potentially undervalued relative to its earnings power.

Benefits of focusing on earnings yield:

• Helps identify undervalued stocks
• Provides a measure of the potential return on investment
• Allows for comparison across different companies and industries

By combining the earnings yield metric with return on capital, investors can find good businesses trading at bargain prices. This approach helps mitigate the risk of overpaying for quality companies or buying low-quality businesses simply because they appear cheap.

5. Long-Term Perspective: Essential for Magic Formula Success

Time horizons of 5, 10, or even 20 years are ideal.

Patience pays off. The magic formula's effectiveness is rooted in its long-term approach. Short-term market fluctuations and investor emotions can lead to temporary underperformance, but over extended periods, the strategy has historically outperformed market averages.

Why a long-term perspective matters:

• Allows time for Mr. Market to recognize undervalued companies
• Smooths out short-term volatility and market inefficiencies
• Capitalizes on the compounding effect of reinvested earnings

Investors who maintain a long-term perspective are better positioned to weather short-term underperformance and reap the benefits of the magic formula's approach. This patience is crucial for achieving superior investment results over time.

6. Outperforming the Market Averages Over Time

Over a 17-year period from 1988 to 2004, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year.

Consistent outperformance. The magic formula has demonstrated its ability to outperform market averages over extended periods. This outperformance is attributed to the strategy's focus on high-quality businesses trading at attractive prices.

Key performance metrics:

• 30.8% annual return over 17 years (1988-2004)
• Outperformed in 95% of three-year periods
• Positive returns in 100% of three-year periods

While past performance doesn't guarantee future results, the magic formula's consistent outperformance across various market conditions suggests its underlying principles are sound and potentially applicable in different market environments.

7. Implementing the Magic Formula Strategy

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.

Step-by-step approach. Implementing the magic formula strategy involves a systematic process of selecting and managing a portfolio of stocks. This structured approach helps remove emotion from investment decisions and ensures consistent application of the strategy's principles.

Key steps in implementing the magic formula:

1. Determine your investment amount and timeline
2. Use screening tools to identify top-ranked stocks
3. Gradually build a portfolio of 20-30 stocks over 9-10 months
4. Hold each stock for one year before re-evaluating
5. Sell losers just before one year and winners just after for tax efficiency
6. Reinvest proceeds into new magic formula stocks

By following these steps, investors can create a diversified portfolio of high-quality, bargain-priced stocks that align with the magic formula's principles.

8. Limitations and Challenges of the Magic Formula

The magic formula strategy can underperform the market for years.

Acknowledging imperfections. While the magic formula has demonstrated long-term success, it's essential to understand its limitations and challenges. This awareness helps investors maintain realistic expectations and stick with the strategy during periods of underperformance.

Key limitations and challenges:

• Short-term underperformance can last for months or years
• Requires discipline to follow during market downturns
• May not work in all market conditions or economic cycles
• Relies on historical data, which may not predict future performance

Understanding these limitations helps investors maintain perspective and avoid abandoning the strategy prematurely. It's crucial to remember that no investment approach works perfectly all the time, and patience is often key to long-term success.

9. The Importance of Patience and Discipline in Investing

If you don't believe that the magic formula will work for you, you'll most likely quit before it has a chance to work!

Mental fortitude required. Successful investing often comes down to patience and discipline. The magic formula's effectiveness relies on an investor's ability to stick with the strategy through both good and bad periods, trusting in its long-term potential.

Keys to maintaining patience and discipline:

• Understand the strategy's underlying principles
• Set realistic expectations for short-term performance
• Focus on long-term goals rather than short-term fluctuations
• Avoid emotional decision-making during market downturns
• Regularly review and rebalance your portfolio according to the strategy

By cultivating patience and discipline, investors can increase their chances of success with the magic formula and other long-term investment strategies.

10. Balancing Risk and Reward in Your Investment Portfolio

Beating the market is not the same thing as making money.

Holistic approach to investing. While the magic formula aims to outperform market averages, it's crucial to consider your overall investment portfolio and risk tolerance. The strategy should be viewed as part of a broader financial plan that aligns with your goals and risk preferences.

Considerations for portfolio balance:

• Determine an appropriate allocation to stocks based on your risk tolerance
• Diversify across asset classes (e.g., bonds, real estate) to manage overall portfolio risk
• Consider your investment timeline and liquidity needs
• Regularly reassess your risk tolerance and adjust your portfolio accordingly

By taking a balanced approach to investing, you can potentially benefit from the magic formula's outperformance while managing overall portfolio risk. This approach helps ensure that your investment strategy aligns with your broader financial goals and risk tolerance.

Last updated: August 19, 2024