Are you looking for a real return on your hard-earned money? Confused by the jargon of the financial world?
A New York Times bestseller, The Little Book That Still Beats the Market introduces and explains a simple formula anyone can use to beat the stock market.
You may be wondering if you should read the book. This book review will tell you what important lessons you can learn from this book so you can decide if it is worth your time.
At the end of this book review, I’ll also tell you the best way to get rich by reading and writing.
Without further ado, let’s get started.
Lesson 1: When putting together your investment portfolio, look at the “return on capital” and the “earnings yield”
If you want to beat Mr. Market, you must buy stocks when they are below their true value and sell them when they are above it.
Two numbers must be considered in order to make an informed decision about the share price.
We’ll start with the earnings yield or the company. This can be used to determine how much the company earns in relation to its stock price.
Divide earnings before interest and taxes (EBIT) by enterprise value to get the earnings yield (EV). The EV of a company is equal to its market value plus its net interest-bearing debt.
EBIT/EV has an advantage over the widely used price-to-earnings ratio (P/E) because it is unaffected by debt or tax rates.
As an example, suppose an office building costs $1 million, has a $800,000 mortgage, and $200,000 in equity. If the EBIT was $100,000, the earnings yield (EBIT/EV) of the building would be 10% ($100,000/$1,000,000).
A 6% interest rate on the $800,000 mortgage yields a 26% earnings yield on the equity purchase price ($200,000). In other words, $100,000 minus $48,000 in interest expense equals $52,000 in pretax income. ($52,000/$200,000 equals 26%)
This earnings yield would change depending on the debt level, but the $1,000,000 purchase price and $100,000 EBIT would remain constant.
A high earnings yield, on the other hand, is insufficient. Based on an additional calculation, the company must be profitable. It is necessary to consider the return on capital (ROC).
Although many factors influence a company’s health, such as its brands, strategy, and so on, the ROC is the simplest to estimate.
Divide the company’s after-tax profit by the book value of its invested capital to calculate the return on invested capital (ROC) (the amount that shareholders, bondholders, and other investors have contributed).
The ROC of a company measures how well it converts investment into profit. For example, if you spent $300,000 to open a restaurant and profited $100,000 in the first year, your ROC would be 33.33 percent. A company is considered successful if it achieves a ROC of more than 25%.
As a result, if you buy shares of companies with a high return on capital at low prices, you will be systematically investing in companies that Mr. Market believes are currently undervalued.
Lesson 2: Return on capital and earnings yield form the magic formula
The previous insight taught you that earnings yields and return on investment (ROC) are important factors to consider when purchasing stocks. However, how should these figures be applied? They should be combined to form a magical formula.
The magic formula combines earnings yield and rate of return into a single measurement.
The ROC is calculated by identifying the top 3,500 companies on a major US stock exchange, such as the NYSE or NASDAQ, and ranking them from one to three thousand based on their ROC. The company with the highest return takes first place.
The same companies are ranked based on earnings yield, with the company with the highest earning yield at the top of the heap.
Finally, we combine the two rankings. If a company ranked first in ROC but 181 in earnings yield, its total score would be 182. (one plus 182). As a result, the firms with the lowest combined ranking will have the best combination of earnings yield and return on capital.
What does this have to do with us? We should invest in these companies!
Over time, the magic formula performs admirably. Between 1988 and 2004, a portfolio of around 30 stocks with the best combined rankings returned around 30% per year, while the market average was only 12%. That is why the formula works.
Lesson 3: Due to the long-term nature of the magic formula, it is not attractive to financial managers who need to perform every year
Why isn’t the magic formula used by every investment manager if it’s such a brilliant money-making strategy?
This is due to the fact that the strategy does not always outperform the market. On average, an investment portfolio based on the magic formula will outperform the overall market average five months out of the year. This is true for 25% of all full-year periods.
Magic formula portfolios, which generated an average of 30% profit per year from 1988 to 2004, frequently underperformed the overall market average for two or more consecutive years.
Professional money managers cannot afford to perform below-average for long periods of time because they must constantly satisfy their clients.
It is difficult to stick with a strategy that may not work for months or years at a time, no matter how effective it may be in the long run.
Money managers do not use the magic formula because the time frame in which they must show profits to their clients is so short.
A manager who is unable to consistently show a profit to their clients will most likely be fired, despite their promise that there will be a profit someday.
While the magic formula works in the long run, most professional investors cannot afford to perform below the market average for an extended period of time. You can, however. It only takes a little perseverance to stick with it through good and bad times.
Lesson 4: Invest in at least 30 stocks of large companies to reduce risk and use tax laws wisely to further maximize your returns
True, the magic formula works, but you must take these precautions to use it correctly.
First, using the magic formula, select stocks from large companies rather than small ones. Because smaller companies have fewer shares to sell, even a slight increase in demand can cause the share price to rise. As a result, you may have difficulty determining a fair price for their shares.
Applying the magic formula to larger corporations makes more sense. A company is considered large if its market value exceeds $50 million (the number of shares multiplied by the stock price).
You should buy stocks in 20 to 30 large companies at a time.
Having fewer stocks raises the possibility of deviating from the magic formula’s healthy average performance.
When an industry event occurs, such as a tanker spill, owning multiple shares can help to mitigate the financial impact. Diversifying your holdings is thus a wise decision.
Finally, you should understand how to use tax laws wisely in order to maximize your profits.
Stocks are held for about a year before being sold. Taxes will determine whether you can sell them slightly earlier or later than this date. In the United States, profits on stocks held for more than a year are taxed at a lower rate.
As a result, you should sell any stock that has lost value before the one-year holding period expires. This reduces your annual income and thus your tax burden.
If, on the other hand, the stock price has risen, do the opposite. Reduce your tax liability by selling them after the one-year period is over.
About the Author
Joel Greenblatt is an American hedge fund manager and author.
You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits is one of his books, as is The Big Secret for the Small Investor: A New Route to Long-Term Investment Success.
He also works as an adjunct professor at Columbia University’s Graduate School of Business.
Buy The Book: The Little Book That Still Beats the Market
If you want to buy the book The Little Book That Still Beats the Market, you can get it from the following links:
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