Hello all, i thought you might want chapter by chapter commentry of the learnings from the book “The Little Book that Beat the Markets”. Whatever orignal thoughts conveyed by author Joel Greenblatt, is just reporduced here in shorter version and as per my understanding. If you like the book’s summary, and wish to implement it, i suggest you to read the book first.

>>Chapter 1:

A business will make Rs. 3,000/- over six years. How much will you pay today for the half of the business?

Well, the answer seems to be very complicated. However, that is the main thing in finding the answer.

If half of business is yours then you will received Rs. 1500/- in six years. Which means obviously you won’t pay Rs. 1500/- today to receive that Rs. 1500/- back in span of 6 years.

Now, paying Rs. 750/- seems reasonable as it will give you back another Rs. 750/- in six years and which literally means you double your money in 6 years i.e. 12% CAGR (Returns). But that is not the return you are looking for as it is too less given the risk involved in business.

Hence, what is the reasonable amount?

Finding this reasonable amount is the purpose of a Magic Formula and hence will be explained by author in this book.

The gist is that, in stock markets, we need to find company that are selling cheap then its actual valuation and buy those companies at a relatively low price.

Author emphasis on Patience as primary requirement to follow this magic formula.

>>Chapter 2:

Simple thing: You have many choices with your money. Suppose you save a bit of money every year say Rs. 1000/- then what would you do with this money. There are multiple options what can you do and they are as follows:

1. Spend Rs. 1000/- on something that will further consume your unnecessary time.
2. Save it under the mattress or piggy bank and earn no interest.
3. Deposit in Bank and earn roughly about Risk-free rate say 6% or buy US Government bond and earn Risk-free rate of return. (Also called minimum return which could be earned)
4. Buy bond issued by companies and the interest rate will depend upon credit quality of the company (usually 12-15%).
5. Invest in some other assets. (This part is explained further – Magic Formula)

>>Chapter 3:

So, what is that “Other Asset” where we can invest? How about investing in a business? A business that earns a net profit of say Rs. 1.2/- per share and asks for Rs. 12/- per equity share. This is pretty good deal as this is straight 10% profit as compared to Risk-free rate of 6%.

However, we have a lot of uncertainty regarding that income of Rs. 1.2/- per share. That uncertainty includes that the company earns Rs. 1.2/- per share currently. But we don’t know whether it will keep on earning Rs. 1.2/- in future as well. There is uncertainty of how the business will grow and whether that Rs. 1.2/- per share can increase to Rs. 2/- or could decrease to Rs. 0.5/- per share as well. Hence, there is lot of risk involved and this involves a lot of estimation and prediction of how will the company perform in the future so that we keep on consistently earning at least 10% annually.

But, how to see all these parameters regarding the estimates, projection and future performance of company? Basically we need to earn more than Risk-free rate of 6% and figuring out that is explained further…

>>Chapter 4:

Prices of stock fluctuates almost every day in the market. We can see huge fluctuations from Rs. 30/- to Rs. 60/- even in a year’s time. But, does that mean that company is earning double than usual? Or does it mean that company with 1 billion share had value of 30 Billion is now worth 60 Billion and a lot has changed for a company and suddenly the profits have doubled? No, it is not. In fact, big companies post almost same profits per share amount (or marginally higher) for every next quarter, still the prices and values of the company in the Market fluctuates so much.

But, the thing is. Why should we care about what the share price of the company is currently going on? If we had been given an option to buy the shares of the company for Rs. 30/-. We, first would have found what the value of the company is and is Rs. 30/- worth buying w.r.t the value of the company.

If value of company is lot higher then Share price, then it is a deal and we should buy it. Let’s say that actual value might be Rs. 60/-. Even if business condition worsened, we still have margin of safely. We bought the stock at Rs. 30/- when we thought value should be Rs. 60/-. Even after business getting affected due to any reasons, the actual value now got down to Rs. 45. We still have enough margin of safely on the stock. (I.e. Margin of safety of Rs. 15/-)

But there are lot of problems here:

1. 1^st, how do we know what is worth of the company or its value? If we don’t know the value how can we decide that Rs. 30/- is cheaper or Rs. 60/- is expensive or both are cheap relative to the value?
2. 2^nd, even if we figured out the value of the company, how can we know that we are right? We might have arrived at the value with lot of assumption and estimation which can go wrong.
3. There are tonnes of market experts. So, if they were to find those stock then they would have bought themselves and hence the push to stock price will make it fairly valued. If they are not able to find those stocks then how can we?

The solutions to the problem will come ahead…

>>Chapter 5:

We know that when Profit per share is Rs. 1.2/- and those share are being sold for Rs. 12/-. On buying we would expect a 10% return. However, there is uncertainty that the profit of Rs. 1.2/- per share will keep on going in future and we will keep on earning 10%. Hence, we have to actually predict the future of business and analyse that whether the company will keep on earning Rs. 1.2/- per share in the future or not. Hence, if we can’t predict the future of business it is hard for us to find the true value of the company.

There are two tricks which will help in understanding the true value of the company though (and this is what known as “Magic Formula”):

Trick 1: Earnings Yield

Now, just imagine that company instead earns Rs. 2.4/- to Rs. 3.6/- per share which is currently trading at Rs. 12 per share. Instead of 10% the returns now would be 20% to 30%.

This is Earnings yield – How much we receive in earnings relative to the purchase price (i.e. we receive Rs. 2.4/- on purchase price of Rs. 12/-). So the EPS (Earnings per Share) is Rs. 1.2/- and purchase price is Rs. 12/- making earnings yield at 10% and similarly for 20%/30% returns as well.

Trick 2: Nature of Business

Nature of Business – i.e. a good business or bad business. There are plenty of ways in defining good business i.e. loyalty of customer, their service, management quality etc. But here, we are going to focus on Return on Capital as a measure of good business. You would rather own a business that earns high return on capital then one which earns low.

Example: a company that invests Rs. 4,00,000/- to set up store and earns Rs. 2,00,000/- in one year has return of capital of 50% v/s a company that invests Rs. 4,00,000/- to set up store and earns Rs. 10,000/- per year. The return of capital is 50% v/s only 2.5%. Hence, choosing a business which invests its money in higher capital return classes is actually a better company.

The details of Return on Capital and Earnings yield are explained further.

>>Chapter 6:

What would happen if we buy share of the company which are bargain price and also the company has very high earning yield along with high return on capital?

Investing in high earning yield and good (High return on capital) business could get us a lot of profits. An analysis of past 17 years historical data of stock market, for a basket of 30 stocks would mean that our Rs. 11,000/- would turn into Rs. 10, 56,000/- and that is a whopping 30.8% return on annual basis. Markets in the similar time has given us return of 12.3% and our Rs. 11,000/- investment would have turned in to only Rs. 79,000/-. Hence buying stocks based on two criteria i.e. earnings yield and return on capital would give us a huge return.

Here is a little analysis of how those basket of 30 stocks will be selected. It will all be done by trading systems or computer systems. First, we will select universe of stocks say 3500 largest companies listed on US Stock Exchanges. Now, we would rank these companies from 1 to 3500 based on their return of capital (higher the return on capital, higher the rank). Now, again we would rank these companies from 1 to 3500 based on their earnings yield (higher earning yield, higher rank). We would combine and take sum of the ranks of 2 criteria’s (i.e. One company has rank of 10 on return on capital and rank of 250 on earnings yield. Then combined rank is 250 + 10 = 260). The first 30 companies with lowest sums (i.e. also highest combined rank) will be eligible for the basket (i.e. selection). Selecting rank 1 from criteria of return on capital but not complimented by good earnings yield will defeat our purpose of selecting high earning yield good companies. Hence, a combination of two just works perfect.

The result of analysis (shown above) is 30.8% yearly return that turns Rs. 11,000/- to Rs. 10, 56,000/- in 17 years w.r.t the stock market average return of 12.3% per year converting Rs. 11,000/- to Rs. 79,000/-

We would examine the conclusion more closely.

>>Chapter 7:

Although it looked that past 17 years data for basket of 30 companies had produced us return of 30.8%, there is high chances that the magic formula got lucky and would have included exceptional companies into the portfolio and hence got such huge returns. Right?

Well, the analysis was not performed for only one portfolio of 30 companies (One magic formula). For each year, top 30 companies were selected and with different combinations as well i.e. 3500 largest companies (Min. value of Rs. 50Mn) in US, 2500 largest companies in US (Assuming that largest 3500 would have small company’s biases and hence could have inflated the returns. It contains companies with min. value of Rs. 200Mn) and also 1000 largest companies in US (Even more extended analysis with companies having min. value or Rs. 1B). The calculation goes as this: 30 Basket companies x for 17 years different baskets x for each 3 combinations i.e. 30 x 17 x 3 = 1530 Magic Formula portfolio. And the result for these many portfolios are that largest 3500 companies produced return of 30.8%, largest 2500 companies produced returns of 23.7% and top 1000 companies had produced 22.9%. When compared to market return of 12.3%, it is still double.

Also, what if the magic formula for some reason would not be able to identify few exceptional stocks and for some reason that stock does not form a part of basket. Right?

Again, to test this, magic formula was conducted by making groups. Take this, a list of top largest 2500 companies were ranked and group of 10 were made containing equal stocks by their rank. So Group 1 would contain companies with top 250 ranks. Next 250 ranks would be in Group 2 and so on till Group 10 which contains last 250 stocks. On conducting analysis for 15 years it was discovered that Group 1 outperformed Group 2. Group 2 outperforming Group 3 and so on in order till Group 10. Hence, it means that selecting top ranked companies would always provide better returns than the markets and other groups down the order. Hence, exceptionally high returns stocks issue is gone as we are earning more returns then other basket of stocks.

Also there is one more advantage, keeping a basket of stocks we are diversifying our risk against any company getting bankrupted. Hence, overall the portfolio will achieve its results even if 1-2 companies in the portfolio performs badly.

One more important question is that Magic formula has worked perfectly nice up till now; but, will it continue to perform in future as well?

We will find out…

>>Chapter 8:

Well, how can our magic formula keep working even if everyone uses this trick? Will this magic formula even work in future?

There is plenty of times when magic formula does not work at all. Magic formula if compared to 12 months a year wise, does not work for 5 months straight. For full year periods, magic formula failed to work once every 4 years. Sometimes even 2-3 years straight the magic formula has not worked at all. Well, that is the main thing in fact. Magic formula sometimes does not works at all in the short run. Short run can be few months to few years as well. But when you take a 17 year average, you will often find the magic formula working and the returns generated are almost double the average market returns.

For long run the magic formula works. There are many funds, where the initial return performance by the funds are way worse than the market. You might even see these funds not performing for straight 3 years. But, once the black period is gone, the next few years returns are so much that the average returns since fund’s inception goes comfortable past the market returns. And, that is the beauty of this magic formula.

Also, there is another plus point. We see that magic formula does not work for short term sometimes. The funds tend to lose its clients and fund managers leave as well. But those who keep patiently sticking to these formula earns huge on a long run. Because there is no time certainty as to when the formula will work, people usually don’t use the formula. Because, everyone does not use this formula, there is no issue of over usage and hampering excess returns. People just can’t wait for so long and keep switching strategies to earn more. For some, waiting for 3 years is not possible due to horizon issues. For some, they don’t want to wait so long and keep their investments stuck for bad returns for continuous 3-4 years. And because of these issues, you see very less people use the magic formula. Hence, because there is no overcrowding for this strategy the returns over long run tend to come.

Hence, Magic formula does not works sometimes in the short run, but it has very good returns track record in the long run (usually more than 5 years).

The next chapter is very important.

>>Chapter 9:

Our level of confidence in the Magic Formula will determine whether we can hang on to a strategy that may be both unpopular and unsuccessful for seemingly long periods of time. Confidence is required because, when returns don’t come for continuous 3 years, we tend to lose patience and try to switch strategies.

In Magic Formula, the companies that has high earnings yield and also good return of capital are the ones we are selecting. Hence, automatically we are selecting above-average Company at below-average value. Here is the explanation:

Magic formula ranks companies based on their earnings yield and return on capital. Hence, a company with high return on capital of say 50% has opportunity to earn Rs. 2, 00,000/- on every Rs. 4, 00,000/- investment. Now because their business earns 50%, it means reinvesting profits into these business will also earn the company 50% more. So, initial year’s profit of Rs. 2, 00,000/- would earn Rs. 3, 00,000/- in the 2^nd year i.e. a 50% growth in earnings as well.

Hence, this opportunity to invest profits at high rates of return is very valuable. Owning a business that has the opportunity to invest some or all of its profits at a very high rate of return can contribute to a very high rate of earnings growth!

So now we know two important things about businesses that can earn a high return on capital. First, businesses that can earn a high return on capital may also have the opportunity to invest their profits at very high rates of return (reinvesting the profits in same business). Second, the ability of re-investing the profits at that same rate of capital will lead to high growth in earnings yield and hence leads to high earnings yields as well. So, buying high return on capital with high earnings yield also goes hand in hand.

But, wait, there is one issue. The company which has such high return on capital will also attract a lot of new entrants in the market. People will starting opening similar shops. Hence, over the time the rate of capital due to competition will fall down to 40%, then 30% and so on will come down to average return on capital up to the point where business is no more attractive.

But here is another thing. The fact that our magic formula is able to find out these companies with huge rate of return on capital also means that at least temporary those companies are earning huge profits. Which also means that these companies might have some special advantage over others so that they are able to earn such high profits. Special advantage like new technology invention, patented product, good brand name, better product, etc.

In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors away from destroying the ability to earn above-average profits.

Hence, the companies which don’t have any special advantage earns only average return on capital and our magic formula won’t include that company in our basket.

In other words, Magic Formula is helping us find Good Companies with high earnings yield at Average value. Hence, buying above-average companies (high return on capital) with below-average price (high earnings yield) is what this formula achieves, which in turn generates huge returns.

>>Chapter 10:

The magic formula has performed even better then what we have portrayed above. Over a short term period as well, the average market returns are lower than the Magic Formula. Magic formula over a 3 year horizon (which is still considered short) has outperformed the market 165 times out of 169 (169 Magic Formula Portfolios). And the worst 3 year horizon Magic Formula’s Portfolio return is 11%, markets worst 3 years return is negative 46%. Hence, magic formula is way too good then average market returns.

Also, the risk in magic formula is lower than the market. There are basically two risk associated here, the risk that alternate investment strategy will outperform and the risk of losing money even after keeping long term horizon. We have seen from above para that the risk of losing money over long term is almost nil and far more less than market. Also, any good portfolio will, over long term, be always profitable. Hence, one needs horizon of over 5 years to get exceptional return.

But, sometimes it happens that share price are stuck at same level for a prolonged period of time and hence there is another risk that the stock price not move towards its fair value for years. But, that is not true always. Smart investors find these bargain stocks and might buy them, pushing the price of shares upwards. Also, smart investor might not buy if there is some negative news around, and for that they will wait out the actual impact of the news. If after the news they still think stocks are bargain then they will buy. Another way the bargain price moves to its fair value is that the company’s management identifies its own company is undervalued and my go for buyback. Also, if value of company is so less, any Mutual Funds, Private Equity Firm will buy them, or merger might happen encoring the value of the shares. But this sometimes happen in even few months and may even take up to few years and hence holding on to the stock and having patience is sometimes more important.

There are few peoples who would not follow magic formula at all and chose to select stocks based on individual analysis. Still magic formula will help these individual stock pickers to make right decisions on their own. How? It is part of chapter 11.

>>Chapter 11:

So, magic formula has another problem, which might compel the analyst to pick companies based on own individual analysis. And that problem is, the Return on Capital and Earnings Yield taken as criteria in the Magic Formula is based on past years earning. Hence, the industry factors change, economies change, company changes, and hence you can’t say what was attained by the company in the past will continue to achieve in future.

Hence, using past data for future prospects of the company is generally not a good idea and there might seem a flaw in the magic formula. So, what is the solution? Rather than plugging blind numbers from the past, just find normalized earnings (Estimation of earnings without any extra-ordinary activity, good or bad). Finding normalized earnings also require judgement, estimation and knowing company’s future prospect among all the others. Also, some temporary issues might continue for the short run and hence we have to estimate prospects for long term period as well. But, taking a long run view is important because your horizon for stocks is long run.

Hence, you have to find normalized earnings by proper estimation (involves risk), and apply to each and every stock you study individually, and find the companies with highest Earnings yield and highest return on capital. And it involves a hell lot of work and efforts. And as an individual analyst you need to do it.

But, wait. If you don’t want to take so much of efforts. Just use the magic formula as it is. Magic Formula still uses past data for earnings yield and return on capital. But, what is does best is that it selects top 20-30 companies to be kept in its portfolio. And due to so many companies, the risk of some companies not performing goes away. This is because there is diversification benefit of having so many companies in one portfolio. And Magic Formula, on average, still achieves better results. Remember, results are achieved on average (i.e. full portfolio basis) whereas, some specific companies return might vary individually.

Hence, simple things. Magic Formula even works on past data, as it has been working for so long. Only thing is now due to many stocks in portfolio, the average results are achieved and returns are not suffered due to individual stock basis.

But, still you want to try using individual stock research. Suggestion is select stocks from top 30 companies generated using Magic Formula. Do your own research in estimating the future prospect of these shortlisted companies. This will still require you to have a good research skills, efforts, company understanding, and industry understanding and so on. Instead of 30 companies in portfolio, take only 7-10 companies based on your individual stock research. Although by this selection, diversification benefit is very less, but your individual skills in selecting stock will still be beneficial to earn returns and drive away some stock specific risk.

>>Chapter 12:

When you have money, you would probably need to invest it in stock markets. Yes, you do, but where will you invest in the money. You might select stock on your own, go to a stock broker, invest in Mutual Funds, invest in Index Funds or hedge funds, and so on. Investing in any of the above ways has still problem to be solved.

When you invest on your own, you would need a lot of expertise in analysing financial statements, business and company as a whole, so that you would be able to select the right stock to invest.

Other way is to invest based on tips given by stock brokers. However, that barely works. Because, most of the tipsters work on some purpose. That purpose might be earning commissions when you buy stock, they themselves have invested and want to push price higher, and so on. Hence, even stockbroker’s tip is not full proofs of earning regular and good returns over time, although it might work for short term horizon.

You have one good option, Mutual Funds. A Mutual Fund on an average keep 50 to 200 stocks in their portfolio. But, again, tracking such a huge number of stocks is difficult. Also, very rarely Mutual Fund are seen providing more than average market returns, especially when we consider the hefty management fees charged by them. And, to select those mutual funds giving above average return, you need to select good managers. Selecting managers and betting money on them is another task and not an easy job for sure. Also there is risk associated with individual investors performing well.

You might invest again in index funds, but it will earn only near market returns and actually less them market when you consider the charges of index fund.

Investing in Hedge Funds has transparency issue, availability only for people who have good money, and hedge funds are risky as well.

Hence, Point is, where there are so many complicated options for you to invest in stock market. These options obviously have specific risk associated with them. Hence, investing on magic formula is so good, takes hardly any time, reliable and works over long term and so on.

So, instead of doing so much of research, wasting time, betting on other people expertise, having to take risk, and also lesser return. Using Magic Formula for above average return with minimal risk is the best option. And any prudent men will always go for investing in Magic Formula Style, considering all the options so far explored in the book.

>>Chapter 13:

By investing in total Rs. 28,000/- over next six years from 2006 to 2011, and then keeping invested for 20 years, that Rs. 28,000/- would get converted to Rs. 3,25,000/- and over 13,00,000/- in another 10 years, i.e. total 30 years. Point to note is, Rs. 28000/- converted to Rs. 3, 25,000/- in 20 years, but Rs. 3, 25,000/- got converted to Rs. 13, 00,000/- in another 10 years. That is power of compounding interest. Your money earns interest, and reinvested interest earns further interest. This is how your money grows at faster rate in the long run. So, even if Magic Formulas return is say 15% (taking to low compared to 30% over 17 year analysis), you would grow your Rs. 28,000/- to Rs. 3,25,000/- and with 20% return it will reach to Rs. 7,52,000/- in 20 years’ time.

Keep in your bank to get simple interest, and you see your money does not grow for any good over 20 year horizon. Point to say is: Magic Formula’s portfolio is the best alternative investment opportunity you will ever get over a long run.

Hence, Magic Formula is really effective way of multiplying your money. You will end up having huge amounts over long term horizon. Happy investing, and all the best with your money, and with Magic Formula.

Step by Step instructions in applying Magic Formula in Markets:

So, applying Magic Formula is the main purpose of this book and the steps to come will help in choosing stocks based on Magic Formula’s Condition. Hence, firstly before starting with the steps, let’s understand few things first:

• Magic Formula’s Portfolio of stocks contain about 20-30 companies. Because it is based on averages which works over whole portfolio. So, we should be focused on keeping 20-30 companies in our portfolio to attain the benefit of diversification.
• Each stock in Magic Formula is held for only a period of one year (not more), hence we need to do some adjustment to attain tax benefits. Time the stocks sale depending upon taxes you pay. Those stocks in loss, can be sold just few days before year ends to record a loss, which can be set-off with other incomes. And those in profits should be sold few days after a year to enjoy benefit of long term capital gain. (Adjusting the sale depending upon your tax system and benefits of taxation you achieve)
• We do not need to buy stocks all at once. Let’s say we discover 7-8 stocks (out of our 20 target portfolio). We buy them, then wait for a month till we get more opportunities to add them. And so on, we complete 20 stocks portfolio over the time. Those stocks, whose year is going to get completed (Because we hold stock for a year), we will replace these stocks with another set of stocks. So, those 7-8 stocks bought in the first month will be replaced with another 7-8 in the 13^th month.
• To find stocks using magic formula, we should have access to screener. Screener is website or application, which gives us filtered list of stock out of all, based on criteria we enter. Hence, we need to put earnings yield, market cap and return on capital as our criteria to get our stocks list screened. Some websites are available for free, and some charge us. Hence, we need to select accordingly. https://www.magicformulainvesting.com/this website is specially designed for Magic Formula but based in US. It’s available for free.
• To follow the above process smoothly without much complications, let’s go with step by step approach.

Approaches:

>Using www.magicformulainvesting.com (Simple)

Go to the website and register. Then, just select the number of stocks you want i.e. 30 or 50, and market cap in $ Million. Click Get Stocks and you will get all top 30/50 stock list directly without giving any conditions (because the conditions are in-built in the website).

Buy top 5-7 companies and invest about 20% to 33% of your total amount. After a month repeat the same process and buy another 5-7 companies. Repeat this until you use all your portfolio amount. After everything is invested, it would result in allocation of about 20-30 stocks and your portfolio has been build.

When, a year is about to get completed for any companies, sell those stock (before a year or after, depending upon tax implication) and replace with another set of top stocks.

Remember that Magic Formula works for long period of time. Hence, you should continue this process for 3-5 years to achieve above average results.

>Using any other stock screener (Bit complicated).

Using any other stock screener means you have to put in some criteria yourself to filter out the stocks. And here is how to do:

1. Filter of Return on Capital: Criteria should be company having minimum of 25% of ROA (Business quality). Mostly it is advised to use EBIT / (Net Working Capital + Net Fixed Asset) as a criteria in place of ROA and it is discussed later**.
   Then, Rank these stocks from 1, 2, and 3 …so on.
2. Earnings Yield: Criteria of company having lowest P/E ratio (in short higher earnings yield). Again rank those from 1, 2, and 3 …so on. Again EBIT / Enterprise Value to be used as criteria for high earnings yield and is discussed. ***
3. Add the ranking two rankings of earnings yield and return on capital, then arrange them from lowest to highest. The lowest total ranked company is usually the company which has met the Magic Formula’s criteria the best.
4. We have to eliminate all utility and financial stocks like Mutual Funds, Banks and insurance companies. One important point to consider is that Banks, NBFCs, and Insurance companies are not considered in the analysis because their business model and ratios used to analyse those companies are different then usual and hence will be inappropriate to consider for Magic Formula. Hence, these companies are eliminated by author Joel Greenblatt.
5. If particular stock has very low P/E ratio say less than 5. Then it might indicate that there are some issues with this company or with the data filtered. Hence, better is to exclude such companies, and this won’t form part in Magic Formula.
6. After a list of stocks is obtained, select top 5-7 and invest 20%-33% of fund. After a month repeat the same, and keep on doing till your fund is over, and your portfolio of 20-30 stocks is made.
7. When, a year’s holding gets about to complete for any stock, sell those (before or after a year, depending upon taxation effect). Replace these sold stocks with another stock using the same formula and criteria as above.
8. Keep on doing this rotation for long term, preferable 5-7 years, for Magic formula to work.

This is just the simple technique of how you could filter out stocks using Magic Formula.

Proxy for Returns on Capital:

Return on Capital = EBIT/ (Net Working Capital + Net Fixed Assets)

Return on capital was measured by calculating the ratio of pre-tax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). EBIT (or earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using operating earnings before interest and taxes, or EBIT, allowed us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.

Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business.

Proxy for Earnings Yield:

Earnings Yield = EBIT/Enterprise Value

Earnings yield was measured by calculating the ratio of pre-tax operating earnings (EBIT) to enterprise value (market value of equity* + net interest-bearing debt). This ratio was used rather than the more commonly used P/E ratio (price/earnings ratio) or E/P ratio (earnings/price ratio) for several reasons.

Enterprise value was used instead of merely the price of equity (i.e., total market capitalization, share price multiplied by shares outstanding) because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings. By using EBIT (which looks at actual operating earnings before interest expense and taxes) and comparing it to enterprise value, we can calculate the pre-tax earnings yield on the full purchase price of a business (i.e., pre-tax operating earnings relative to the price of equity plus any debt assumed). This allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields.

A Random Walk Spoiled:

Random walk sometimes referred to as Efficient Market Theory, which means all the publicly available information of a company, is reflecting in its the stock prices, i.e. the stock is fairly valued at almost all times. Many money managers, hence, had their own theory of selecting better priced bargain stocks but they have failed to beat the markets, which led to rise demand for index funds to earn only market returns. (Funds which replicates the market returns).

Yes, over the years many strategies have been built to beat the market, but these strategies have often been criticized as there are many issues in them. These issues include the strategy having survivorship bias (company which has delisted is not considered, hence returns go elevated), look-ahead bias (information available now, but would not have been available at the time when the portfolio was to be built), Small Companies filtered which are not suitable for buying huge stakes, transaction cost involved, and so on. Still Magic Formula despite all those problems tend to work then most of those sophisticated theories in the market.

Many strategies, use value investing principles as it has been observed that this principle beat the overall market over long run. Hence, people following these strategies tend to beat the market over the long run. However, most do not have the patience to hold on for so long and also long periods of underperformance, have made it even difficult for the investors to stick to value investing strategy.

Another thing is that, although the strategy works, they work more on Small-cap and Mid-cap stocks as compared to larger stocks. This is because small-caps and mid-caps are less in analysts focus and hence, they do not trade at their fair value for long periods of time. Whereas, large caps are more usually in focus and hence, they mostly trade at their fair values. Hence, small-caped and mid-caped stocks are more likely to present us opportunity to find bargained priced stocks.

Also, due to a larger number of small-caped and mid-caped stocks in the markets, it is more obvious that a many of them will be lightly analysed and there are higher chances that most of these are not fairly valued. This also means that bargain priced stock amount small-cap and mid-cap categories are easier to find using basic formula like return on capital and earnings yield.

However, Magic Formula has attained the feat of beating both, large cap stocks as well as small caps. Other strategies do not fare that well when it comes to investing in large cap segments.

Even very sophisticated market-beating strategies, while showing excellent results in general, do not fare nearly as well as the relatively simple magic formula in the large-cap universe.

Conclusion:

Using Magic Formula of investing in High Return on Capital and High Earnings yield stock is the simplest, effortless and best strategy to beat the market over long runs. It involves a lot lesser risk due to more number of stocks in the portfolio, relatively easier to follow than lots of complex strategies in the market, provides exceptional returns over all market capitalization stocks along with the least expertise requirement.

I have also written a short summary of this book which might save you a lot of time. Click here, to read directly the summary.

Thank You!