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.
