“In this concise summary of The Little Book That Still Beats The Market, you will discover my essential takeaways organized chronologically, designed to save time and serve as a convenient reference for future use. When relevant, I include a personal note to express my opinion or key take-away from the text, adding a personalized touch to the summary. To dive deeper into the complete book, I have provided an affiliate link to Amazon, where you can effortlessly purchase it for global delivery.” – Jeroen Snoeks.
How “The Little Book That Still Beats The Market” Broadened My Perspective
As long as you know for 100% you are buying a stock at a bargain price, it’s not necessary to know the exact “real value” of it. While having a low price relative to the historical cost of assets (a low price to book value) may be an indication that a stock is cheap, high earnings relative to price and to the historical cost of assets are much more direct measures of cheapness and should yield better results.
I consider this Appendix, found at the end of this summary, to be the most valuable section of this book as it provides a clear insight into Joel Greenblatt’s valuation metrics and methods. Although the magic formula might be a good investment strategy for some, for me it can be used for idea generation at most (as I have confidence in my own judgment 😊).
In the following sections, I’ve detailed my key takeaways from each chapter in the same order they appear in the book. This structure should make it easier for you to cross-reference any particular chapter if you decide to delve deeper into the subject matter.
Introduction to the 2010 Edition
I had a vision of a dad or a grandma I was trying to help actually ending up losing some or their hard-earned savings by not having the proper resources to implement the strategy. So, we quickly put together www.magicformulainvesting.com as a free resource for readers of the book that both did the calculations correctly and used a high-quality source for the data.
Introduction to the Original Edition
After more than 30 years of investing professionally and after 14 years of teaching at an Ivey League business school, I am convinced of at least two thing:
- If you really want to “beat the market”, most professionals and academics can’t help you, and
- That leaves only one real alternative: You must do it yourself.
The formula will take significantly less time and effort than doing the “work” yourself, and will provide better results for most people, but you can decide which way to go when you’re done reading.
If anyone asks you to loan them money or to invest with them over the long term, they better expect to pay you more than 6 percent a year. Why? Because you can get 6 percent a year without taking any risk. All you have to do is lend money to the U.S government, and they’ll guarantee that you receive your 6 percent each and every year, along with all of your money back after 10 years.
- You can stick your money under the mattress. (But that plan kind of stinks.)
- You can put your money in the bank or buy bonds from the U.S. government. You will be guaranteed an interest rate and your money back with no risk (up to $100,000 are guaranteed by the government, as long as you trust this guarantee).
- You can buy bonds sold by companies or other groups. You will be promised higher interest rates than you could get by putting your money in the bank or by buying government bonds – but you could lose some or all your money, so you better get paid enough for taking the risk.
- You can do something else with your money …
Whenever the long-term government bond is paying less than 6 percent, we will still assume the rate is 6 percent, as we want to make sure we earn a lot more than we could without taking any risk. Obviously, when the rates rise to 7 percent or higher, we will use that higher number.
Here’s what you need to know:
- Buying a share in a business means you are purchasing a portion (or percentage interest) of that business. You are entitled to a portion of that business’s future earnings.
- Figuring out what a business is worth involves estimating (okay, guessing) how much the business will earn in the future.
- 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-years U.S. government bond. (Remember: 6 percent was the absolute minimum annual return.)
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.
The author’s answer: Who knows and who cares? You just have to know they do!
The stock market is Mr. Market! In short, you are never required to act. You alone can choose to act only when the price offered by Mr. Market appears very low (when you might decide to buy some shares) or extremely high (when you might consider selling any shares you own to Mr. Market). Benjamin 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.
The two concepts – requiring a margin of safety for your investment purchases and viewing the stock market as if it were a partner like Mr. Market – have been used with much success by some of the greatest investors of all time.
Personal note: As I have also written down and summarized my key-takeaways from Benjamin Graham’s book “The Intelligent Investor“, where he outlines the concepts of Mr. Market and the margin of safety, you can read my notes in the Investment Book section on UndervaluedEquity.com too.
- 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.
- 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.
- From what we’ve learned so far, you wouldn’t know a bargain-priced stock if it hit you in the head.
The earnings yield is calculated by dividing the earnings per share for the year by the share price.
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 Mr. Market goes crazy sometimes and offers us unbelievable bargain prices, we won’t recognize them. But rather than focusing on all the things we don’t know, let’s go over a couple of things we do know.
- You would rather have a higher earnings yield than a lower one.
- Are we buying a good business or a bad business? Look at the quality of its products or services, the loyalty of its customers, the value of its brand, the efficiency of its operations, the talent of its management, the strength of its competitors, or the long-term prospects of its business. All of these assessments would also involve making guesses, estimates, and/or predictions. as we already agreed, that’s a pretty hard thing to do.
- You would rather own a business that earns a high return on capital than one that earns a low return on capital.
Personal note: I appreciate Joel Greenblatt’s acknowledgment that predicting the future is a challenging endeavor, as I share the belief that it often involves mere speculation and a positive interpretation of past events.
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.
- 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.
- 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 in lower ones. In other words, businesses that earn a high return on capital are better business that earn a low return on capital.
- Combining points 1 and 2, buying good business at bargain prices is the secret to making lots of money.
Benjamin 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 of the company’s assets in a fire sale (he called these stocks by various names: bargain issues, net-current-assets stocks, or stocks selling below their net liquidation value). Graham stated that it seems “ridiculously simple to say” that if one could buy a group of 20 to 30 companies that were cheap enough to meet the strict requirements of his formula, without doing any further analysis, the “results should be quite satisfactory“. In fact, Graham used this formula with much success for over 30 years.
The Magic Formula starts with a list of the largest 3,500 companies available for trading on one of the major U.S. stock exchanges. It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital (where 1 is assigned to the company with the highest ROC). Next, the magic formula follows the same procedure, but this time, the ranking is done using earnings yield (where 1 is assigned to the company with the highest earnings yield). Finally, the formula just combines the rankings, where the formula looks for the companies that have the best combination of those two factors.
- The magic formula works for companies both large and small.
- The magic formula was extensively tested. The great returns do not appear to be a matter of luck.
- The magic formula ranks stocks in order. As a result, there should always be plenty of highly ranked stocks to choose from. The magic formula has been an incredibly accurate indicator of how a group of stocks will perform in the future!
Personal note: Out of the 3,500 stocks, it’s intriguing to note that the top-performing 1,000 stocks had the smallest market capitalization. This suggests that smaller companies outperformed their larger counterparts. Consequently, (when evaluating the Magic Formula myself,) I should prioritize smaller-cap stocks.
On average, in five moths out of each year, the magic formula portfolio does worse than the overall market. Often, the magic formula doesn’t work for a full year or even more.
If everyone used the formula, the bargains would disappear and the magic formula would be ruined!
- The magic formula appears to work very well over the long term.
- The magic formula often doesn’t work for several years in a row.
- Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row.
- For the magic formula to work for you, you must believe it will work and maintain a long-term investment horizon.
Owning a business that has the opportunity to invest some or all of its profits at a very high rate of return can contribute to a very high rate of earnings growth!
Two important things about businesses that can earn a high return on capital:
- They may also have the opportunity to invest their profits at very high rates of return.
- A high return on capital may also contribute to high rate of earnings growth.
Good businesses attract competition.
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.
- 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.
- Companies that can 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.
- 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.
- 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.
I’m clearly not a good sailor, I still love sailing. And that’s the same way many people feel about investing in the stock market. They may not be particularly good at it, or they may not know whether they are any good at it, but there’s something about the process or the experience that they enjoy.
The magic formula was tested over a recent 17-year period (from January 1, 1988 to December 31, 2004). A portfolio of approximately 30 stocks (selected from the largest 1,000 stocks) was held throughout that time, with each individual stock selection held for a period of one year. Following the formula for any three-year period in a row, the magic formula beat the market averages 95 percent of the time. During this three-year period, you would never have lost money.
Once the reality of the situation is known, smart investors will buy stock if the bargain opportunity still exists. Other ways that stock prices can move towards fair value is via buybacks or takeover bids.
Although over the short term, Mr. Market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to Mr. Market. This means that if you buy shares at what you believe to be a bargain price and you are right, Mr. Market will eventually agree and offer to buy those shares at a fair price.
Personal note: If you’re absolutely certain that you’re acquiring a stock at a significant discount, pinpointing its precise “true value” becomes less critical.
How can you pick stocks intelligently, even if you’ve decided not to follow the magic formula?
The magic formula picks stocks that have both a high earnings yield (companies that earn a lot compared to the price we have to pay) and a high return on capital (companies that earn a lot compared to how much the company has to pay to buy the assets that create those earning.) As predicting future earnings is too hard, the magic formula uses last year’s earnings. Ideally, beter than blindly plugging in last year’s earnings, we should be using estimates for earnings in a normal year. (A normal year is one in which nothing extraordinary or unusual is happening within the company, its industry, or the overall economy.)
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.
- Most people have no business in investing in individual stocks on their own!
- Reread summary point number 1.
- But if you must … and you can actually predict normalized earnings several years down the road, use those estimates to figure out earnings yield and return on capital. Then, use the (sorting and selecting) principles of the magic formula to look for good companies at bargain prices based on your estimates of normal earnings.
- If you truly understand the business that you own and have a high degree of confidence in your normalized earnings estimates, owning five to eight bargain-prices stocks in different industries can be a safe and effective investment trategy.
- On Wall Street, there ain’t no tooth fairy (so don’t believe in fairy tales).
- Nothing much rhymes with magic formula (as according to the author it’s the best investment strategy for most people wanting to invest in the stock market).
- Your step-by-step instructions for beating the market using the magic formula are coming right after the next chapter.
If you become a successful investor find a way to give back to society, preferably by investing in the improvement of the education system.
We should make sure that our plan includes holding at least 20 to 30 stocks at one time, as the magic formula works on average.
For taxable accounts we want to adjust the holding period of one year slightly. For individual stocks in which we are showing a loss from our initial purchase price, we will want to sell a few days before our one-year holding period is up. For those with a gain, we will want to sell a day or two after the one-year period is up. In that way, all of our gains will receive the advantages of the lower tax rate afforded to long-term capital gains, and all of our losses will receive short-term tax treatment.
To start, you should be adding five to seven stocks to your portfolio every few months until you reach 20 or 30 stocks in your portfolio. Thereafter, as stocks in your portfolio reach the one-year holding mark, replace only the five to seven stocks that have been held for one year.
Option 1: MagicFormulaInvesting.com
- Go to: https://www.magicformulainvesting.com/
- Follow the instructions for choosing company size (e.g., companies with market capitalizations over $50 million, or over $200 million, or over $1 billion, etc.).
- Follow the instructions to obtain a list of top-ranked magic formula companies.
- 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.
- Repeat step 4 every two to three months until you have invested all of the money you have chosen to allocate to the magic formula portfolio. After nine or ten months, this should result in a portfolio of 20 to 30 stocks.
- Sell each stock after holding it for one year. For taxable accounts, sell winners after holding them a few days more than one year and sell losers after holding them a few days less than one year. Use the proceeds from any sale and any additional investment money to replace the sold companies with an equal number of new magic formula selections (step 4).
- Continue this process for many years (minimum of three to five years, regardless of results).
- Feel free to write to Joel and thank him.
Option 2: General Screening Instructions
- 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.)
- From the resulting group of high ROA stocks, screen for those with the lowest price/earning (P/E) ratios. (This will take the place of earnings yield from the magic formula study.)
- Eliminate all foreign companies from the list. In most cases, these will have the suffix “ADR” (for “American Depositary 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 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.
Personal note: The reason for excluding foreign companies from the selection at Step 3 is because those companies often report their financial statements in their local currency, while their stock prices are listed in USD. Stock screeners typically don’t factor in these currency disparities. Furthermore, foreign companies often bundle multiple common stocks into one ADR, another factor usually overlooked by screeners.
Afterword to the 2010 Edition
Warren Buffet (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. 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 actually destroys value over the years. Owning a good business that can continually invest its earnings at a high rate of return can actually create additional value over the years and effectively increase the original margin of safety.
The magic formula strategy can underperform the market for years.
Earnings-related numbers were based on the latest 12-monthh period, balance sheet items were based on the most recent balance sheet, and market prices were based on the most recent closing price.
Return on Capital
EBIT / (Net Working Capital + Net Fixed Assets)
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:
- EBIT (or Earnings Before Interest and Taxes) was used in place of reported earnings because companies operate with different levels of debt and different tax rates. For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed).
- Net Working Capital + Net Fixed Assets (or tangible capital employed) was used to figure out how much capital is actually needed to conduct the company’s business. Net Working Capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded) but does not have to lay out money for its payables, as these are effectively an interest-free loan (short-term interest-bearing debt was excluded from current liabilities for this calculation). A company must also fund the purchase of fixed assets necessary to conduct its business. 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.
Note: Intangible assets, specifically goodwill, were excluded from the tangible capital employed calculations.
EBIT / Enterprise Value
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:
- Enterprise Value (Market Value of Equity + Net Interest-Bearing Debt) was used instead of merely the price of equity (i.e., total market capitalization) because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings.
- By using EBIT and comparing it to Enterprise Value, we can calculate the pretax earnings yield on the full purchase price of a business. This allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yield.
Personal note: I consider this Appendix to be the most valuable section of this book as it provides a clear insight into Joel Greenblatt’s valuation metrics and methods.
A Random Walk Spoiled
The magic formula achieved the greatest performance with the smallest-capitalization stocks studied because there are more stocks to choose from and because smaller stocks are more likely to be lightly analyzed by Wall Street and, as a result, more likely to be mispriced.
While having a low price relative to the historical cost of assets (a low price to book value) may be an indication that a stock is cheap, high earnings relative to price and to the historical cost of assets are much more direct measures of cheapness and should work better.
Reading the original book instead of a summary offers a comprehensive understanding, emotional connection, appreciation of the author’s writing style, direct support for the author, and the chance to discover hidden gems. Enhance your reading experience by purchasing the book through my affiliate link: Get the Book on Amazon.