The Magic Formula

Greenblatt presents a “Magic Formula” for buying good companies at good prices. A good company and good price is identified based on two financial ratios.

 (ROIC)  Return on Invested Capital represents “good company” while Earnings Yield represents “good price" 

ROIC tells us how much cash a business is able to generate in relation to the capital invested in them. As an investor, it means how much money you are able to take away from the business in relation to what you have invested.

 Earnings Yield tells us an an investor how expensive the company with respect to the earnings it generates.  Is a rupee worth more than or lesser than itself at the given instance. This is a key ratio to determine an investment.

The Magic Formula considers these ratios in equal weight and ranks all companies as Good Company (ROIC) and Good Price (Earnings Yield).  Their ratings on both counts are added together.  As per the formula, the investor buys and holds the companies with the best combined rankings for a period of only one year. He then sells them and does the same allover again. This method is clean and simple, yet effective for someone who wants wants to learn about investing. You can start by reading the little book on investing.  

In India, we need to consider an important parameter, which is quality of the management. We have to consider management that are highly focused and believes in allocation of capital. Companies that dilute equity very often will not reward investors.  As a noted investor quoted about JSPL, a company operating in a sector where there external problems. the company although is in the commodities (steel & power) had returned a CAGR of 37% over the last 15 years (share price from Rs 1 (2001) to Rs 156 (2014). It goes to prove that if the management is good, it can grow and survive in any market.

A Money Making machine from 2011

A friend recently narrated how a huge investment he recently made has turned very negative. He was surprised that the stocks had made money for many others but failed to help him. I had a realization of sorts after this discussion. It’s the attitude of investing small amounts over a long period of time versus that of investing large amounts over short period of time that makes the results different. People who follow the latter are wrongly hoping that they will get lucky in the ‘get rich quick’ schemes in stock market. This never happens, invariably after you invest the stock typically goes down as our investments are timed in such ways. We invest when we hear a friend  bragging how he made quick money and very often such prices will reverse to the mean causing losses to ourselves.

If you are sure about the fundamentals of the company and its growth prospects, don’t sell the stock only because there is no movement in the price. The stock price will move up sooner or later and when it does, it would make up for the lost time.

My own experience teaches the same.

On 25^th May 2011, 4 years ago I had blogged about this stock when it was quoting for Rs 3,925. On 27^th May 2014, it was quoting the same price Rs 3,928. Anybody who had invested would have been frustrated except if he is an owner of the stock of the business. He continues to stay invested because he is a part owner and he is interested if the company is growing its earnings and revenues, keeping debt in control. Now like magic, the market works wonders. From June 2014, the stock price of this scrip kept moving north nonstop and now quotes at Rs Rs 8,200.

The way to look at this is that the stock price went up from Rs 3,900 to Rs 8,200 in 4 years accumulating an approximate 18% CAGR (per year return). What decisions went into investing, and what decisions made you to hold it for 4 years? Read Here

Lessons.  

Remain “extremely passive” with your investments;

buy quality stocks; companies that have great competitive advantage

and companies with honest management.

One should never hesitate to pay for quality and then remain passive.

There are investment options always in the market, one has to develop the right attitude to win the Stock Markets. It starts by being business literate.