Joel Greenblatt
So, here’s what you need to know: 1. Buying a share in a business means you are purchasing a portion (or percentage interest) of that business. You are then entitled to a portion of that business’s future earnings. 2. Figuring out what a business is worth involves estimating (okay, guessing) how much the business will earn in the future. 3. The earnings from your share of the profits must give you more money than you would receive by placing that same amount of money in a risk-free 10-year U.S. government bond. (Remember: Last chapter we set 6 percent as your absolute minimum annual return when government bond rates fall below 6 percent.) (Location 374)
No! It makes no sense that the values of most companies swing wildly from high to low, or low to high, during the course of each and every year. On the other hand, it seems pretty clear that the prices of the shares in most companies swing around wildly each and every year. All you have to do is look in the newspaper to see that that’s true. (Location 423)
Graham referred to this practice of buying shares of a company only when they trade at a large discount to true value as investing with a margin of safety. (Location 463)
1. Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period. In effect, the stock market acts very much like a crazy guy named Mr. Market. 2. It is a good idea to buy shares of a company at a big discount to your estimated value of those shares. Buying shares at a large discount to value will provide you with a large margin of safety and lead to safe and consistently profitable investments. (Location 488)
That 10 percent return, calculated by dividing the earnings per share for the year by the share price, is known as the earnings yield. We then compared the earnings yield of 10 percent we could receive from an investment in Jason’s business with the 6 percent return we could earn risk free from investing in a 10-year U.S. government bond. We concluded, without too much trouble, that earning 10 percent per year on our investment was better than earning 6 percent. Of course, although that analysis was simple, we identified a bunch of problems. (Location 523)
In short, all of our problems seem to boil down to this: It’s hard to predict the future. If we can’t predict the future earnings of a business, then it’s hard to place a value on that business. If we can’t value a business, then even if Mr. Market goes crazy sometimes and offers us unbelievable bargain prices, we won’t recognize them. But rather than focusing on all the things that we don’t know, let’s go over a couple of the things that we do know. (Location 534)
The first point related to price—how much we receive in earnings relative to our purchase price. In other words, is the purchase price a bargain or not? But beyond price, we might also want to know something about the nature of the business itself. In short, are we buying a good business or a bad business? (Location 550)
You would rather own a business that earns a high return on capital than one that earns a low return on capital ! (Location 571)
that 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 that crazy Mr. Market has decided to literally give away. You can achieve investment returns that beat the pants off even the best investment professionals (including the smartest professional I know). You can beat the returns of top-notch professors and outperform every academic study ever done. In fact, you can more than double the annual returns of the stock market averages! (Location 575)
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. In other words, a higher earnings yield is better than a lower one. 2. Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital. 3. Combining points 1 and 2, buying good businesses at bargain prices is the secret to making lots of money. (Location 585)
investment results with a high degree of safety. Graham’s formula involved purchasing companies whose stock prices were so low that the purchase price was actually lower than the proceeds that would be received from simply shutting down the business and selling off the company’s assets in a fire sale (Location 609)
Although Graham’s formula has continued to work over the years, especially during periods when stock prices are particularly depressed, in today’s markets there are usually few, if any, stocks that meet the strict requirements of Graham’s original formula. (Location 618)
what would happen if we decided to only buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield)? What would happen? Well, I’ll tell you what would happen: We would make a lot of money! (Or as Graham might put it, “The profits would be quite satisfactory!”) (Location 637)
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. Investing at that rate for 17 years, $11,000 would have turned into well over $1 million. (Location 643)
The formula starts with a list of the largest 3,500 companies available for trading on one of the major U.S. stock exchanges.5 It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500. Similarly, the company that had the 232nd best return on capital would be assigned a rank of 232. 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 a rank of 3,500. Likewise, the company with the 153rd highest earnings yield out of our list of 3,500 companies would be assigned a rank of 153. Finally, the formula just combines the rankings. The formula isn’t looking for the company that ranks best on return on capital or the one with the highest earnings yield. Rather, the formula looks for the companies that have the best combination of those two factors. So, a company that ranked 232nd best in return on capital and 153rd highest in earnings yield would receive a combined ranking of 385 (232 + 153). A company that ranked 1st in return on capital but only 1,150th best in earnings yield would receive a combined ranking of 1,151 (1,150 + 1). (Location 655)
2. Today, few companies meet the strict requirements outlined by Graham. 3. We have designed a new magic formula—a formula that seeks to find good companies at bargain prices. 4. The new formula appears to work. In fact, it appears to work too well. 5. Before piling every penny we have into the magic formula, we should probably examine the results more closely. (Location 684)
For instance, the magic formula may be picking companies that are so small that few people can really buy them. Often, 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 be pretty large. (Location 700)
So instead of choosing from the largest 3,500 companies, let’s look at just the largest 2,500 companies. The smallest companies in this group have a market value of at least $200 million. (Location 710)
But what if we take it one step further? Let’s look back and see what happened when we narrowed the group to just the largest 1,000 stocks—only the companies with market values over $1 billion. (Location 715)
Throughout the 17 years of our study, we held a portfolio of roughly 30 stocks. Each stock selection was held for a period of one year.8 In all, over 1,500 different stock picks were made for each of the tests (largest 3,500 stocks, largest 2,500 stocks, and largest 1,000 stocks). When we combine all of our tests, they are the results of over 4,500 separate magic formula selections! (Location 726)
What if those few bargain opportunities were to disappear for some reason? What if Mr. Market simply wised up a bit and stopped offering us those few incredible bargains? If that happened, we really would be out of luck. So let’s try a little experiment. (Location 732)
That also means that if we can’t, for some reason, buy the top 30 stocks as ranked by the magic formula, it’s no big deal. Buying the next 30 should work pretty well also. So should the next 30! In fact, the whole group of top-ranked stocks appears to do well. (Location 758)
As it turns out, there are plenty of times when the magic formula doesn’t work at all! Isn’t that great? In fact, on average, in five months out of each year, the magic formula portfolio does worse than the overall market. But forget months. Often, the magic formula doesn’t work for a full year or even more. That’s even better! (Location 797)
The magic formula portfolio fared poorly relative to the market averages in 5 out of every 12 months tested. For full-year periods, the magic formula failed to beat the market averages once every four years.10 For one out of every six periods tested, the magic formula did poorly for more than two years in a row. During those wonderful 17 years for the magic formula, there were even some periods when the formula did worse than the overall market for three years in a row! (Location 809)
So what’s the point? The point is that if the magic formula worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain-priced stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined! That’s why we’re so lucky the magic formula isn’t that great. It doesn’t work all the time. In fact, it might not work for years. Most people just won’t wait that long. (Location 842)
Perhaps now you’re beginning to see why most everyone else won’t be using the magic formula. Though some may take it out for a spin, most won’t last past the first few months or years of poor performance. (Location 856)
The magic formula works—long-term annual returns of double, or in some cases almost triple, the returns of the market averages—only those good returns can get pretty lumpy. Over shorter periods, it may work or it may not. When it comes to the magic formula, “shorter” periods can often mean years, not days or months. In a strange but logical way, that’s the good news. (Location 860)
Quick Summary 1. The magic formula appears to work very well over the long term. 2. The magic formula often doesn’t work for several years in a row. 3. Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row. 4. For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon. (Location 866)
The magic formula chooses companies through a ranking system. Those companies that have both a high return on capital and a high earnings yield are the ones that the formula ranks as best. Put more simply, the formula is systematically helping us find above-average companies that we can buy at below-average prices. (Location 890)
So now we know two important things about businesses that can earn a high return on capital. First, businesses that can earn a high return on capital may also have the opportunity to invest their profits at very high rates of return. Since most people and businesses can invest their money at only average rates of return, this opportunity is something special. Second, as we just learned, the ability to earn a high return on capital may also contribute to a high rate of earnings growth. Certainly, that’s good news for the companies chosen by the magic formula. (Location 923)
In short, 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. (Location 948)
So by eliminating companies that earn ordinary or poor returns on capital, the magic formula starts with a group of companies that have a high return on capital. (Location 956)
Quick Summary 1. Most people and businesses can’t find investments that will earn very high rates of return. A company that can earn a high return on capital is therefore very special. 2. Companies that earn a high return on capital may also have the opportunity to invest some or all of their profits at a high rate of return. This opportunity is very valuable. It can contribute to a high rate of earnings growth. 3. 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. 4. By eliminating companies that earn ordinary or poor returns on capital, the magic formula starts with a group of companies that have a high return on capital. It then tries to buy these above-average companies at below-average prices. 5. Since the magic formula makes overwhelming sense, we should be able to stick with it during good times and bad. (Location 971)
As you recall, the magic formula was tested over a recent 17-year period. A portfolio of approximately 30 stocks selected by the magic formula was held throughout that time, with each individual stock selection held for a period of one year. Performance was then measured over 193 separate one-year periods. (Location 1006)
Remember, while that may not sound all that bad, underperforming for two years in a row is actually pretty hard to take! But here comes the good news. 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)! (Location 1013)
All those numbers you just read about were based on the results achieved by choosing from only the largest 1,000 stocks (those with a market value over $1 billion). The results from choosing from the largest 3,500 stocks (market values over $50 million), a group of stocks individual investors can generally buy, were even better. Every three-year period tested (169 of 169) was positive for the magic formula portfolios, and every three-year period beat the market averages (169 out of 169). (Location 1021)
Though not easy to do, even maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum time frame for any meaningful comparison of the risks and results of alternative investment strategies. (Location 1045)
So here’s the other thing you need to know about Mr. Market: • Over the short term, Mr. 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: Mr. Market gets it right. (Location 1054)
First, there are a lot of smart people out there. If the price offered by Mr. Market is truly a bargain, some of these smart people will eventually recognize the bargain opportunity, buy stock, and push the price closer to fair value. This doesn’t have to happen right away. Sometimes uncertainty about the prospects for a particular company over the near term will keep potential buyers away. Sometimes the influence of emotions can last for years. But here’s the thing. Eventually, the problem or the reason for the emotional reaction is resolved. (Location 1066)
In short, over time the interaction of all of these things—smart investors searching for bargain opportunities, companies buying back their own shares, and the takeover or possibility of a takeover of an entire company—work together to move share prices toward fair value. Sometimes this process works quickly, and sometimes it can take several years. (Location 1081)
To calculate these ratios, the magic formula doesn’t look at future earnings. That’s too hard. The magic formula uses last year’s earnings. (Location 1108)
very misleading. But that’s precisely what the magic formula does! In fact, often the near-term prospects for the companies selected by the magic formula don’t look so good. In many cases, the outlook for the next year or two is downright ugly. But that’s one reason the magic formula can find companies whose prices seem like bargains. The magic formula uses last year’s earnings. If, instead, estimates for this year’s or next year’s earnings were used, many of the companies selected by the magic formula might not look like such bargains at all! (Location 1112)
So what should we be doing? Ideally, better than blindly plugging in last year’s earnings to the formula, we should be plugging in estimates for earnings in a normal year. (Location 1117)
That’s why, if we actually use the magic formula, we’ll want to own 20 or 30 stocks at one time. In the magic formula’s case, we want the average (that is, the average return for a portfolio of stocks chosen by the magic formula). Since average results for the magic formula will, hopefully, mean extraordinary investment returns, owning many different stocks chosen by the magic formula should help ensure that we stay pretty close to that average. (Location 1142)
If you still want to buy individual stocks despite all the warnings, don’t even try to make a lot of predictions. Limit your stock investments to a small number of “good” companies that are available at bargain levels. For those few investors who are capable of estimating normal earnings several years into the future and placing values on businesses, owning just a handful of bargain-priced stocks is the best way to go. As a general rule of thumb, if you are truly doing good research and have a good understanding of the companies that you purchase, owning just five to eight stocks in different industries can safely make up at least 80 percent of your total portfolio. (Location 1150)
Rather than just blindly choosing stocks that catch your fancy or blindly accepting the output of the magic formula, how about combining both strategies? Start with the magic formula and put together a list of top-ranked stocks. Then choose a few of your favorites by whatever method you want. You must, however, choose solely from the top 50 or 100 stocks as ranked by the magic formula.23 Using this method, you should still place at least 10 to 30 stocks in your portfolio (Location 1159)
That means adding five to seven stocks to our portfolio every few months until we reach 20 or 30 stocks in our portfolio. Thereafter, as stocks in our portfolio reach the one-year holding mark, we will replace only the five to seven stocks that have been held for one year. (Location 1399)
Use return on assets (ROA) as a screening criterion. Set the minimum ROA at 25%. (This will take the place of return on capital from the magic formula study.) • From the resulting group of high ROA stocks, screen for those stocks with the lowest price/earning (P/E) ratios. (This will take the place of earnings yield from the magic formula study.) • Eliminate all utilities and financial stocks (i.e., mutual funds, banks, and insurance companies) from the list. • Eliminate all foreign companies from the list. In most cases, these will have the suffix “ADR” (for “American Depository Receipt”) after the name of the stock. • If a stock has a very low P/E ratio, say 5 or less, that may indicate that the previous year or the data being used are unusual in some way. You may want to eliminate these stocks from your list. You may also want to eliminate any company that has announced earnings in the last week. (This should help minimize the incidence of incorrect or untimely data.) • After obtaining your list, follow Steps 4 and 8 from the magicformulainvesting.com instructions. (Location 1438)
Ben Graham taught us that leaving a large margin of safety when we invest is the most important concept in investing. In other words, figure out what something is worth and then pay a lot less. Leaving a large spread between the value of a company and the price we pay will create a margin of safety and lead to long-term investment success. (Location 1463)
But these bargain opportunities will generally go to the investor who keeps the disparity between price and value in mind, rather than to those who make decisions based on emotion. (Location 1470)
The magic formula seeks to find a group of companies that on average are trading at a bargain price relative to their true value. It seeks that margin of safety. It does this by finding companies that earn a lot relative to the price we are paying. (Location 1471)
The formula systematically ranks companies based upon how cheap they appear relative to their earnings, and since it is a formula, Mr. Market’s emotions are left completely out of the equation. (Location 1474)
Essentially, Buffett (strongly influenced by his partner, Charlie Munger) said buying a business at a bargain price is great. However, buying a good business at a bargain price is even better. Good businesses usually grow in value over time. Poor businesses can shrink in value. When buying a poor business, what appears at first to be a large margin of safety may shrink or even disappear completely as continued investment in the poor business (think Just Broccoli) actually destroys value over the years. For the good business, it is the opposite. Owning a business that can continually invest its earnings at a high rate of return (think the 50 percent returns on each new Jason’s Gum Shop) can actually create additional value over the years and effectively increase the original margin of safety. (Location 1479)
Unfortunately, it is the short term that gives us some problems. The magic formula has some serious flaws. The two most important are actually pretty big. First, often the formula doesn’t work. One of the reasons I know this is the large number of e-mails I received after the first edition of the book was published. It’s really tough to stick with a strategy that hasn’t worked for six months, a year, or even longer. This is especially true for a strategy that suggests buying 20 or 30 companies selected by a computer. (Location 1496)
Almost all of the companies selected by the formula are currently out of favor for one reason or another. The building boom is over, health-care reform will demolish earnings, the consumer is overextended; there are always great reasons not to own almost all of the stocks that are ranked highly on the magic formula list. In fact, many of the companies selected do not beat the market. (Location 1500)
But here’s an idea. Why don’t we pick and choose from the highest-ranked stocks on the magic formula list rather than buying them all? Plenty of people wrote in over the last five years to suggest this change to the magic formula strategy. Maybe we can just eliminate the pharmaceutical companies that may get hurt from the changes under health-care reform, or the consumer stocks that will suffer during a coming recession, or other companies that for one reason or another don’t look so great right now. Of course, this does make perfect sense. The only problem is that we haven’t yet found a good way to do it. Most of the companies selected by the magic formula are facing headwinds or uncertainty of some sort. (Location 1513)
So, flaw number one is pretty clear. The magic formula strategy can underperform the market for years. But here’s something important to remember. If the formula actually worked every month, every quarter, and every year (and then some fool decided to write a whole book about it), pretty much everyone would follow the formula. The prices of the stocks selected by the formula would be pushed higher and eventually the formula would stop working. In a sense, the great thing about the formula is that it’s not so great! (Location 1528)
But we’re also faced with flaw number two. In some ways, it’s even bigger than flaw number one. While it may seem like an obvious point, it’s also a problem that I sincerely wish I had emphasized more the first time. It’s simply this: Beating the market is not the same thing as making money. Since we are buying a portfolio that is 100 percent long the stock market, if the stock market goes down, our portfolio may well go down, too. If the market drops 40 percent and we beat the market by losing only 38 percent, this is small consolation. (Location 1535)
In fact, when given a choice, 97 percent of those using the new site have chosen to have the formula implemented for them rather than making some individualized choices and implementing it themselves. (Location 1640)
This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons. (Location 1667)
Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business. (Location 1673)
loan (short-term interest-bearing debt was excluded from current liabilities for this calculation). In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment. The depreciated net cost of these fixed assets was then added to the net working capital requirements already calculated to arrive at an estimate for tangible capital employed. (Location 1677)
This ratio was used rather than the more commonly used P/E ratio (price/earnings ratio) or E/P ratio (earnings/price ratio) for several reasons. The basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business. (Location 1691)
Luckily, the magic formula study doesn’t appear to have had any of these problems. A newly released database from Standard & Poor’s Compustat, called “Point in Time,” was used. This database contains the exact information that was available to Compustat customers on each date tested during the study period. The database spans 17 years, the time period selected for the magic formula study. By using only this special database, it was possible to ensure that no look-ahead or survivorship bias took place. (Location 1747)
Many studies over the years have confirmed that value-oriented strategies beat the market over longer time horizons. Several different measures of value have been shown to work. These strategies include, but are not limited to, selecting stocks based upon low ratios of price to book value, price to earnings, price to cash flow, price to sales, and/or price to dividends. Similar to the results found in the magic formula study, these simple value strategies do not always work. However, measured over longer periods, they do. Though these strategies have been well documented over many years, most individual and professional investors do not have the patience to use them. (Location 1760)
Another problem with these simple methods is that, though they work well, they work far better with smaller-and medium-capitalization stocks than with larger stocks. This should not be surprising, either. Companies that are too small for professionals to buy and that are not large enough to generate sufficient commission revenue to justify analyst coverage are more likely to be ignored or misunderstood. As a result, they are more likely to present opportunities to find bargain-priced stocks. This was the case in the magic formula study. The formula achieved the greatest performance with the smallest-capitalization stocks studied. (Location 1766)