This is a top 5 takeaways video summary of The Little Book That Beats the Market, by Joel Greenblatt, the famous inventor of the magic formula. What should you be doing with all your hard-earned money? You could … Put it under a mattress Lend it to a bank Lend it to a company Or, you could invest it in a company, in the stock market. This is probably the best alternative. The problem is just that most people have no business investing in individual stocks on their own, or, as Joel Greenblatt puts it: “Choosing individual 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 just still an idiot.” There is a solution though. It’s all too early in the video for me to reveal it, but let’s just say that it rhymes with the bagic mormula. Takeaway number 1: The madness of the markets Think of a company, any company. Oh, that’s a good one. Yeah, Amazon it is. During the last year, you could have bought Amazon for as low as $1377, and as high as $2012, a price difference of about 50%.. Not just that, but the value of the whole company bounced from about a $1 trillion, down to approximately $650 billion, and then back up to $1 trillion again! Well, what’s your point? you may ask. My point is that, Amazon – the business – didn’t shift in value that quickly. The market is simply overreacting to the information that it is presented with. But this all may just be a fluke, maybe you, when I asked you to pick a company, happen to pick an extremely volatile one. All right, then. I’ll give you another shot. Think of a company. What was that? Okay sure. Yeah, Gap should do. During the last year, you could have bought Gap, America’s largest fashion retailer, for as little as $18 per share (actually, that’s the current price) and as high as $31 per share. That’s an even bigger difference, more than 70%! Do you think that Gap sold 70% more clothes ten months ago than they do today? NO! Clearly, at times, the market doesn’t know what it is doing. Takeaway number 2: How much is a business worth? When looking at these fluctuations, it’s fairly simple to tell that the market isn’t always efficient. Sometimes, greed is ruling and prices are too high, and at other times, fear is ruling, and the prices are too low. Suppose that the value of the Amazon (as a business) fluctuated between $1,500 and $1,700 during the last year, while the prices fluctuated between $1,377 and $2,012. If you could state this with any kind of certainty, becoming rich trading Amazon stocks would be a really simple task. Just buy it whenever the price goes way below $1,500. and sell it whenever it goes way above $1,700. The problem is it is not that simple. Let’s take an example. One of your friends owns a shop called “The Swedish Merchant”. It sells only Swedish stuff. The shop made a profit of $100,000 last year. How much would you be willing to pay for it, knowing this? Well, your guess is as good as mine (as long as you guessed somewhere between $500,000 and $2 million). In the stock market, you’re typically provided with more information than this before you ask to determine the price of a business, but the difficulties are the same nonetheless. Firstly, $100,000 is just what The Swedish Merchants earned last year. We must determine if it, after our purchase, will be able to generate more or less than that, in the coming year. Secondly, we must decide how confident we are in that prediction. And thirdly it’s not just about the next year, potentially we could own The Swedish Merchant for a very long time. So we have to estimate (okay, guess), how much the business will earn 5 to 10 years from now as well, in order to be able to set a definite price tag on it. Head over to my summary of The Dhandho Investor for more on this. Takeaway number 3: PE and ROA So far, we’ve concluded that stocks sometimes sell at a discount from their underlying value, but that it’s very difficult to decide WHEN that is happening. So is it hopeless? No, obviously not, because otherwise I would be wasting your time, which is something I would never do. Unless of course, I would make a pointless fill-in clip. Let me present The Swedish Merchant’s most fearsome competitor – “Just Broccoli”. The Swedish Merchant earns $100,000 per year, like I presented before, while Just Broccoli earns $50,000. The price of the businesses is $1 million each. Which one would you rather buy, everything else equal? You would buy The Swedish Merchant, of course. Here, you only pay $10 for every $1 in earnings. In Just Broccoli’s case, you pay $20 for every $1 in earnings. The Swedish Merchant would pay your initial investment back in 10 years, compared to Just Broccoli’s 20 years. In the stock market, the most common way of measuring this, is through the so called price to earnings, or p/e ratio. The p/e ratio is calculated by taking a business current price and dividing it by its earnings. The p/e of The Swedish Merchant is 10, and that of Just Broccoli is 20. This is the first point of this takeaway – you would rather own a business with a low p/e than a high one. Simultaneously, price is not everything. Even buying at a low p/e can result in a disastrous investment. You must also make sure that you buy a good business. This is where return on assets, or ROA, comes into play. Let’s say that building that store of The Swedish Merchant cost $500,000, and the store of Just Broccoli also cost $500,000. Everything else equal, would you rather invest in the company that can build stores with $100,000 in profits, for $500,000, or the company that can build stores with $50,000 in profits, for $500,000? Once again, you would prefer The Swedish Merchant’s business¨. This ratio is referred to as return on assets, or ROA. The higher, the better. It says something about the quality of the business, and with comparable companies, it can often show you which of the companies that possess the best moat, something that Warren Buffett loves to see in his investments. For more on important ratios to consider when making an investment, please see my summary of The Interpretation of Financial Statements, by Benjamin Graham. Takeaway number 4: The magic formula If you stick to buying good companies, or in other words those with a high ROA, while buying these companies at low prices, or in other words when their p/e ratios are low, you will end up buying underpriced businesses. Joel Greenblatt’s even constructed a system that will do just that for you, which he calls “the magic formula”. It’s simply ranking companies according to their combined score in these two regards – the quality and the price of the business. Intuitively, it does make a lot of sense. And when back testing it, it does make a lot of financial sense as well. During the 17 years period that Joel Greenblatt evaluated the magic formula, it outperformed the overall market by about 18%, returning 30.8% per year rather than 12.3% per year. With such a return, $10,000 turned into almost a million in 17 years, as compared to the markets more modest increase to just $70,000. Some of the companies that you’ll invest in using this formula, will turn out to be crappy investments. But the important thing is that ON AVERAGE, it will help you to find true bargains. If you’re not impressed by the results yet, consider what happened when Joel Greenblatt divided companies into ten different groups, ranking them with the formula. As you can see, it’s quite a good predictor. The best group performed better than the second-best, and the second-best perform better than the third-best, and so on. Crazy! Takeaway number five: Step-by-step instructions Here comes a step-by-step instruction on how to invest using the magic formula. But, just remember … “The ideas and strategies presented on this channel should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. Please remember that past performance may not be indicative of future results.” 1. Go to magicformulainvesting.com 2. Choose a company size. 50 million or bigger should do. 3. Follow the instructions on the site to get a list of top-ranked magic formula companies. 4. Buy between five and seven of these companies. Spend 20%-33% of the capital that you intend to invest. 5. Repeat step 4 every two to three months, until all your capital is invested. This should result in a portfolio of about 20 to 30 stocks. 6. Sell the stocks after holding them for a year. For tax purposes, hold the winners a few days longer than a year, and the losers a few days shorter. Repeat step 4 with the money from your selling. 7. Continue the process for many years If you are like me, and you find investing to be a very challenging and stimulating interest, that you don’t want to throw away for some automatic formula (with a name that makes it sound like a scam, by the way), you could use it for screening purposes only. For example, find the top 100 companies according to the magic formula and then pick your favorite 10 out of those. A quick summary: Market prices fluctuate more than underlying business values. It’s difficult to estimate the future earnings of a company, and therefore also what a fair price of that company should be. Most investors have no business doing this. P/E and ROA are two of the most (if not the most) important quantitative factors to consider when buying stocks. According to the magic formula, if you buy stocks with a low P/E and a high ROA, you will outperform the market by a wide margin over time. Go to magicformulainvesting.com and get started! And last but not least .. It is difficult to come up with something that rhymes with magic formula. Cheers!