Little Book That Beats Market
Mutual Funds Are Safe Investment Tool, Returns Are Below Average
Mutual funds, in which investments from many people are pooled, usually come with a high management fee. So although they often yield decent returns, by the time you’ve subtracted the fees, you’re often left with below-average returns.
What is Earning Yield
This tells you what the business earns in relation to its share price.
The earnings yield is calculated by finding the ratio of earnings before interest expenses and tax (EBIT), to enterprise value (EV). The EV is the market value plus the net interest-bearing debt aka mortgage.
How To Tell If Company Is Profitable
To tell us if the company is actually profitable. That is, we need to look at the return on capital (ROC).
ROC is calculated by dividing the after-tax profit by the book value of invested capital (the total amount of money invested by the company’s shareholders, bondholders, and so on).
ROC reveals how effective a company is at transforming investment into profit
Anything above 25 percent indicates that a company is doing well.
So if you buy shares of companies that have a high return on capital at low prices, you’ll systematically buy into companies which are currently undervalued by Mr. Market.
The companies with the lowest combined ranking (ROC + Equity Yield) therefore have the best combination between both factors of earnings yield and ROC.
So what does this mean? It means you should be buying shares from these companies!
The magic formula does a really good job over time. Over a 17-year period from 1988 to 2004, a portfolio of around 30 stocks with the best combined rankings returned on average about 30 percent per year, whereas the market average was a mere 12 percent. So the magic formula really pays off.
As the magic formula is a long term strategy, it is unattractive to financial managers who need to perform every year.
All it takes is some patience to stick with magic formula during the good and the not-so-good times.
1 Year Action
When in profit, book profits after 1 year to see reduced capital gains tax
When in loss, sell stocks before 1 year to see reduced taxes.
Reference Materials
www.magicformulainvesting.com
Last updated