The Little Book That Beats The Market

Getting started is a big deal. Takes a lot of discipline to save any money. Much easier and more immediately rewarding to find something to buy.
If you do save, you have a number of different options:
Put your money under your mattress (but it’ll just lose value)
Put your money in a bank or buy US gov bonds – guaranteed an interest rate and money back
Buy bonds sold by other companies – promised higher interest rates but you could lose all your money, so you better get paid enough to take that risk
Or you can do something else with it…in next chapter
Makes the point about how important the 10 year gov bond is. That duration is important because it’s a long time, and so comparable to a long term investment choice. Therefore it means if anyone asks you to loan them money or invest with them for a long time, they better expect to pay you more than the 10 year yield. Because you can get that without taking any risk.

The other option with your money is to invest in a business.
Buying shares in a business entitles you to a share of the future earnings of that company.
In this case, Jason’s chewing gum shop.
To decide whether to invest, you have to work out whether they’re giving you a good deal. i.e is paying 120k for 1% of Jason’s future gum profits going to give you a good return?
First, use the information companies provide. What did they sell and how much did that bring in, what did it cost to sell those products (COGS), how much did they spend on rent/wages/heating/electricity/accounting admin etc (selling, general and administrative costs), and what was their tax bill on this income. After all that, you’re left with net income.
Say Jason’s net income was 1.2 mill. If you invest 120k for 1%, in year one you’d get a 10% return on your investment. Now compare that with the gov bond yield. Much higher – good!
Well, a good start. Now you need to build a picture of how much money you think Jason can earn next year and the year after, and so on. What are his customers like, what’s competition like, etc….

Uses an example of big, well known businesses that, in any given year, always have big differentials between high and low stock price
Stocks prices move around wildly over short time periods but that doesn’t mean the value of the underlying business has changed much….the stock market acts like a crazy guy called Mr Market
It’s a good idea to buy shares at a big discount to what you estimate it to be worth. This gives you a large margin of safety (Graham’s value investing concept) and can lead to safer, more consistently profitable investments
But, while all this is well and good, estimating the value of a business is v difficult. Not to mention competitive…

All our problems stem from the fact it’s hard to predict the future. If we can’t predict the future, we can’t place a value on the business.
But rather than focus on what we don’t know, just look at two things you do know.
Invest in businesses at bargain prices by finding stocks with high earnings yields, companies that earn more than others relative to the price you pay.
Make sure they’re good businesses, so look for ones that also have high returns on capital. His example of two shops, both which cost 400k to set up and run. But one earns 200k a year and the other makes 10k. Focus your attention on the 200k earner because that shop is able to earn a 50% return every year on the investment it made. The other is better off buying a 10 year treasury, because it offers a higher yield, and so a better return on their capital.

Ben Graham has a magic formula, which said you want to buy companies below the price you could sell their assets for. By doing that you could earn very good returns with big margin of safety
Today few companies meet that criteria though.
Magic formula in this book. Rank all stocks by best to worse, for earnings yield and return on capital. Those with the best combination are the ones to own.
At the time of publication, this formula earned 30% annual returns for the last 30 years. 10k became 1m.

Put the magic formula to the test.
It works for both big and small companies
Crucially, and unlike Graham’s formula, this one ranks stocks in order so there should always be highly ranked stocks to choose from. And it’s been an incredibly accurate predictor of how stocks will do in future.

Magic formula looks great but how can it keep working once everyone knows about it?
Really good news – it doesn’t work all the time. It had a very successful 17 year test period but during that it did poorly relative to the market 5 out of 12 months a year, failed to beat the market once every four years. One in every six years, it did badly two years in a row. And sometimes more than three years in a row.
Most people won’t stick with it when it does badly, so it’ll be fine.
But for the formula to work for you, you have to really believe in it and keep a long term perspective. Otherwise you’ll jump out.

Most of us can’t find investments that earn very high rates of return. So companies that can earn a high return on capital are special.
They might be able to invest some or all of their profits at high rates of return (like opening another shop). That’s valuable because it can lead to high earnings growth.
Companies that achieve high return on capital are likely to have some sort of special advantage, or they’d be competed away.
The magic formula then tries to buy these above average companies at below average prices.
Since the formula is easy and makes so much sense, we should be able to stick with it.

If Mr Market is crazy, what’s to guarantee he’ll ever pay a fair price for what you think are bargain stocks.
Over time, Mr Market is very reasonable and works on facts. The value of a company.
Tends to work over 2-3 years. For a few reasons. Smart people find bargain opportunities, companies buy back their own shares, or the business is taken over by another company – all these things work together to move share prices to fair value.

Picking stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.
But if you still want to pick stocks, not based on the magic formula, you have to do the work. Predict what ‘normal’ earnings will be several years in future, use those estimates to work out an earnings yield and return on capital. Then look for good companies at bargain prices, based on these estimates. (The magic formula is backward looking but works because it picks 30-40 stocks and the average does a good job)
If you really know what you’re doing and have a high degree of confidence in your estimates, owning 5-8 bargain stocks in different industries can be a safe and effective strategy.

Nothing comes easy in the market. There’s no tooth fairy to take the pain away.
Picking managers, advisers or stocks is fraught with issues. Buying the index is good, but delivers average.
The magic formula really is a good, viable, market beating alternative. The hard part is making sure you understand why the formula makes sense, and continuing to believe in it even when friends, experts, the media, or market are saying otherwise.

Investing is of limited value to society so make sure you give back. Help the education, science, healthcare system. That’s of social good and over the long term will help productivity, and so economic/market growth.

For the magic formula & screen built for the book: www.magicformulainvesting.com