Magic Formula
description
Transcript of Magic Formula
Using the “Magic Formula”
by Larry
Holmes
Disclaimer
This is not personal investment advice or a recommendation to buy or sell any particular security and
past performance in not necessarily an indication of future performance
Disclaimer
All personal investment decisions should be made in the context of your own financial planning goals
and tolerance for risk
Disclaimer
I am not affiliated with Joel Greenblatt or his firm and I don’t benefit
financially from the sale of his books
The Little Book That Beats The Marketby Joel Greenblatt
• The founder and a managing partner of Gotham Capital
• Average annual returns of over 40% for over 20 years
There’s a crazy guy named Mr. Market
“… if you stick to buying good companies … and to buying
those companies only at bargain prices … you can end up
systematically buying many of the good companies that crazy
Mr. Market has decided to literally give away.”
-- The Little Book That Beats The Market (p. 45)
Question: What’s a good business?
Question: What’s a good business?
Answer: One with a high return on capital
Question: What’s a bargain price?
Question: What’s a bargain price?
Answer: A business with a high earnings yield
Okay, so what’s the Magic Formula?
Return on Capital
EBIT / (Net Working Capital + Net Fixed Assets)
Earnings Yield
EBIT / Enterprise Value
“… what would happen if we decided to only buy shares in good businesses
(ones with high returns on capital) but only when they were available at bargain prices
(priced to give us a high earnings yield)?”
“What would happen? Well, I’ll tell you what would happen…
We would make a lot of money!”
-- The Little Book That Beats The Market (p. 51)
From 1988-2004, “owning a portfolio of approximately 30 stocks
that had the best combination of a high return
on capital and a high earnings yield
would have returned approximately
30.8 percent per year.”
-- The Little Book That Beats The Market (p. 52)
Note: The S&P 500 index returned 12.4 percent per year
Question: Why will the Magic Formula
continue to work after everybody knows about it?
Question: Why will the Magic Formula
continue to work after everybody knows about it?
Answer: Because it doesn’t always work
“The magic formula portfolio fared poorly to the market
averages in 5 out of every 12 months tested.”
“For full-year periods, the magic formula failed to beat the market averages once every four years.”
“For one out of every six periods tested, the magic formula did
poorly for more than two year in a row.”
“During those wonderful 17 years for
the magic formula, there were even
some periods when the formula did worse than the overall market for
three years in a row!”
-- The Little Book That Beats The Market (p. 70)
Step 1
Step 2
magicformulainvesting.com
Step 3
Follow the instructions to get a list of the best businesses
selling at a bargain price
Step 4
Buy five to seven of the top-ranked companies
Note: Smaller accounts may want to use brokers like foliofn.com
Step 5
Repeat Step 4 every two to three months. After nine or ten months you should have a
portfolio of 20 to 30 stocks
Step 6
Sell each stock after holding it for one year. Use the proceeds to buy more Magic Formula stocks
according to Step 4
Step 7
Continue the process for many years
Note: Don’t even think about evaluating performance for at least three to five years
Step 8
Send Joel Greenblatt a note and say thank you!