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By: Joel Greenblatt

Rating: B-

It is extremely difficult to find a good financial professional who can guarantee you large returns on your money.

Stockbrokers: They get paid by selling you investment products, regardless of how profitable they are. They are not incentivized to make you good returns. Just salesmen.

Mutual Fund Managers: Mutual funds yield decent returns. Managers require a high management fee. The management fee eats into your returns leaving you with below-average returns.

Index Funds: A non-actively managed mutual fund that essentially buys the entire market. Very low fees. Good returns! Keep it simple stupid.

The stock market values of most companies swing drastically over short periods for no rational reason.

If you were to draw a graph showing the stock prices of Google or Disney over the last 5 years, it would look like a jagged line going up and down trending up. It wouldn’t be a gradual upward sloping line. Why?

Human emotion. Sometimes people are overly optimistic due to some piece of news or quarterly report about a company. Then the next moment they are unreasonably negative about the outlook for the same reason. Crowds follow the sentiment and it moves the share price. Human emotions not the profitability or financial health of a company cause the price to jump up and down.

Look at the “earnings yield” and the “return on capital” when putting together your investment portfolio.

Earnings Yield:

Earnings Yield = Earnings before interest expenses and tax (EBIT)/Enterprise Value (EV)

This tells you what the business earns in relation to its share price.

Return on Capital:

Return on Capital (ROC) = After-tax Profit/Book Value of Invested Capital

This is how effective a company is at transforming investment into profit.

Theoretically, if you buy shares of a company that have a high return on capital at low prices, you will be buying into companies that are currently undervalued. 

The magic formula combines earnings yield and return on capital.

Rank the biggest 3,500 companies available for trading on the US Stock Exchange for earnings yield. In a separate list, do the same for ROC.

Create a final list that adds the rankings from each list together. Company XYZ is number 5 on earnings yield and 300 on ROC. The combined ranking is 305.

Invest in the companies with the lowest combined scores.

As the magic formula is a long term strategy, it is unattractive to financial managers who need to perform every year. 

Duh.

To reduce risk, invest in at least 30 stocks of big companies and use tax laws intelligently to further maximize your profit.

The formula only works for LARGE companies.

You should own at least 20 to 30 large company stocks at a time. I.e. diversification.

Use the tax code appropriately.

Hold your stocks for at least 1 year to be eligible for long term capital gains rates.

Conclusion:

This is not my advice! I am not an advisor! I invest in low fee index funds for the long-term. I use my entertainment envelope to invest in individual stocks for fun.

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