s, largest 2,500 stocks, and largest 1,000 stocks).When we combine all of our tests, they are the results ofover 4,500 separate magic formula selections! So it wouldbe very difficult to argue that luck was a major factor. Butthere must be some other problem, right?*See the Appendix section for more details.
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How about this? While it’s pretty nice that the magicformula can find 30 good companies that Mr. Market hasdecided to “throw away” at bargain prices, what if itcan’t? What if those few bargain opportunities were todisappear for some reason? What if Mr. Market simplywised up a bit and stopped offering us those few incredible bargains? If that happened, we really would be out ofluck. So let’s try a little experiment.Starting with the largest 2,500 companies, what if weranked them again using the magic formula? In otherwords, what if we ranked them from 1 to 2,500, from bestto worst? Remember, the formula is looking for companies that have the best combination of a high return oncapital and a high earnings yield. So the companies thatappeared to be in good businesses and available at bargainprices would be ranked closer to number 1, while the companies losing lots of money that were offered at expensiveprices would be ranked closer to 2,500.Now what if we divided those 2,500 companies into10 equal groups based on their rankings? In other words,Group 1 would contain the 250 companies that the magicformula viewed as good companies at bargain prices,Group 2 would be the second-highest-ranked group of250 companies, Group 3 would be the third-highestranked group, and so on. Group 10, therefore, would be
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a group of 250 stocks that the magic formula ranked asbeing poor companies at expensive prices.So what would happen if we did this every month for17 years? What if we held each of those stock portfolios(each containing roughly 250 stocks) for one year and calculated the returns? Well, take a look (see Table 7.2).Gee, that’s interesting. The magic formula doesn’t justwork for only 30 stocks. The magic formula appears to workin order. The best-ranked stocks perform the best and as theranking drops, so do the returns! Group 1 beats Group 2,Group 2 beats Group 3, Group 3 beats Group 4, and so on,straight down the line from Group 1 to Group 10. Group 1,our best-ranked stocks, beats Group 10, our worst-rankedstocks, by over 15 percent a year. That’s pretty amazing!TABLE 7.2 Annualized Return (1988–2004)Group 1
17.9%
Group 2
15.6
Group 3
14.8
Group 4
14.2
Group 5
14.1
Group 6
12.7
Group 7
11.3
Group 8
10.1
Group 9
5.2
Group 10
2.5
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In fact, it appears as though the magic formula canpredict the future! If we know how a group of companiesis ranked by the magic formula, we have a pretty goodidea of how well that group will perform on average as aninvestment in the future. That also means that if we can’t,for some reason, buy the top 30 stocks as ranked by themagic formula, it’s no big deal. Buying the next 30 shouldwork pretty well also. So should the next 30! In fact, thewhole group of top-ranked stocks appears to do well.That may also solve one of our other potential problems. Remember how Ben Graham had his own “magicformula”? Buying a group of stocks that could meet thestrict requirements of Graham’s formula was a great wayto make money. Unfortunately, in today’s market, few, ifany, companies qualify for purchase under Graham’s original formula. That means Graham’s formula isn’t as useful as it once was. Fortunately, our magic formula doesn’tseem to have that problem. It is merely a ranking formula.By definition, there always have to be stocks that rank atthe top. Not only that, because the formula appears towork in order, we’re not limited to just the top 30 stocks.Since the entire group of top-ranked stocks does well,there should always be plenty of high-performing stocks tochoose from!For those of you keeping score on the sidelines, it’slooking pretty good for the magic formula. Come on.
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That “ranking stocks in order” thing—man, that’s prettyscary. It’s been nice arguing back and forth about whetherthe magic formula really works, but the winner of that battle is pretty obvious. Maybe we should just stop the fightright now before somebody gets hurt?Alas. Not so fast. Sure, the evidence is pretty convincing. But all that means is that the magic formula hasworked in the past. How do we know the magic formulawill continue to work in the future? After all, with mebeing such a blabbermouth, why won’t everyone startusing it? Won’t that ruin everything?Well, after we look at the summary, let’s see . . .1. The magic formula works for companies both largeand small.2. The magic formula was extensively tested. Thegreat returns do not appear to be a matter of luck.3. The magic formula ranks stocks in order. As aresult, there should always be plenty of highlyranked stocks to choose from. The magic formulahas been an incredibly accurate indicator of how agroup of stocks will perform in the future!4. Next chapter, we’ll have to discuss whether themagic formula can continue to get such greatresults. (That would be nice!)
Chapter Eight
I ADMIT IT. My knowledge of history is a little fuzzy.* Iguess I should have listened better in class. But there’sone part of our history that has always baffled me. I neverreally understood how we won the Revolutionary War.Here we were, these 13 little colonies, up against thestrongest country in the world. England had the best navy,the mightiest army, the most money, and yet our scrappylittle ragtag group of soldiers pulled out a victory! How’dthat happen? Well, I have a theory. Given my limitedknowledge, I don’t know whether my theory has been*Though my knowledge of Bob Newhart’s old comedy routines is quitegood.
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extensively studied. But the way I see it, we won becausewe were fighting a bunch of complete idiots!After all, the British strategy left a lot to be desired.On one side, you had British soldiers standing in plainsight, perfectly lined up, wearing, of all things, bright redcoats, while shooting in unison! I’m sure it looked quitenice. On the other side, you had our guys, a messy, disorganized hodgepodge of soldiers, hiding behind rocks andtrees, shooting back at a bunch of conveniently arrangedbright red targets! No wonder we won!But here’s the part I don’t get. I can’t imagine thiswas the first time the British fought like that. In otherwords, despite what I think, the British way of fightingmust have actually worked in the past. My only questionis—how? For all I know, they’d been doing it that way forhundreds of years and apparently—whether it makes senseto me or not—with a great deal of success. Yet followingthe same game plan that had worked so well in the pastclearly wasn’t a good strategy going forward. The Britishfound that out the hard way.So what about us? We’re about to march off, armedwith what looks like a great game plan. We have a magicformula that makes sense and has produced phenomenalresults in the past. We expect to have a lot of success withit in the future. But before we all line up to collect ourmoney, we better stop and think about one obvious
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problem: How can our strategy keep working after everyone knows about it? If we can’t find a good answer, likethe British, we may end up as just another easy target.Well, first, here’s some really good news. As it turnsout, there are plenty of times when the magic formuladoesn’t work at all! Isn’t that great? In fact, on average,in five months out of each year, the magic formula portfolio does worse than the overall market. But forget months.Often, the magic formula doesn’t work for a full year oreven more. That’s even better!Imagine buying a book that tells you to invest realmoney in a group of stocks whose names were spit out bya computer. Imagine diligently watching those stocks eachday as they do worse than the market averages over thecourse of many months or even years. Now imaginedeciding enough is enough. No more trusting that stupidbook or that mindless computer. You’re going to roll upyour sleeves and investigate the companies you purchasedand the outlook for the businesses you actually own. Aswe’ll find out later, imagine the horror when you realizethat if you had only investigated these companies for a fewminutes before buying your shares, there is no way youwould have touched many of them. Finally, despite awfulperformance and the disagreeable prospects of the stocksthat you own, imagine vowing to continue following theadvice of that stupid book and that mindless computer!
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But why even worry about all this? After all, themagic formula works. We proved it last chapter! We’regoing to do really well, so there’s no need to worry aboutmonths or years of poor performance. And though thatsounds right, unfortunately, looking at the statistics foronly our very successful 17-year test period, it turns outthere’s actually plenty to worry about.The magic formula portfolio fared poorly relative tothe market averages in 5 out of every 12 months tested.For full-year periods, the magic formula failed to beat themarket averages once every four years.* For one out ofevery six periods tested, the magic formula did poorly formore than two years in a row. During those wonderful 17years for the magic formula, there were even some periodswhen the formula did worse than the overall market forthree years in a row!Think it’s easy to stick with a formula that hasn’tworked for several years? Do you think the typical reaction goes something like “I know this hasn’t worked fora long time,” or “I know I just lost a lot of money,” but“Let’s keep doing what we’re doing!”? I assure you, itis not.*Annual returns were calculated from January 1988 to January 1989, February 1988 to February 1989, and so on, through the end of 2004. In all,193 separate one-year periods were examined.
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Take, for example, the case of the author with thebest-selling investment book. For his book, the authortested dozens of stock-picking formulas over a period ofmany decades to determine which of those strategies hadbeaten the market over the long run. The book was excellent and well-reasoned. The author then opened a mutualfund based on buying only those stocks picked by the mostsuccessful formula of the dozens he had tested.The fund then proceeded to perform worse than themajor market averages for two of its first three years. Forone of those years, the fund underperformed the marketaverage by 25 percent! After three years, the fund wasperforming poorly relative to competing funds and thebest-selling author—the guy who did the tests, the guywho wrote the book—decided to sell his fund managementcompany to somebody else! In fairness, I don’t think theauthor gave up on his formula, but clearly he saw betteropportunities elsewhere! Had he known that that samefund, the one managed strictly according to his formula,would come back over the next three years to be one ofthe top-performing mutual funds since the time of itsinception (even including the tough first few years), perhaps he would have stuck with it longer!But that’s not unusual. The unpredictability of Mr.Market’s moods and the pressures of competing withother money managers can make it really hard to stick
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with a strategy that hasn’t worked for years. That goes forany strategy, no matter how sensible and regardless ofhow good the long-term track record is. Let’s take a lookat the experience of a good friend of mine who happens tobe the “smartest money manager I know.” Though hedoesn’t automatically buy stocks that his computer-basedformula spits out, he does follow a disciplined strategy ofchoosing companies to buy only from the list of companies his formula ranks the highest.He used this strategy very successfully for 10 years athis previous investment firm, and nine years ago he set outto form his own money management firm using the samebasic principles. Business wasn’t too good for the firstthree or four years, as the same strategy that had been sosuccessful in the past drastically underperformed the returns of competing money management firms and the major market averages. Nevertheless, the “smartest moneymanager I know” strongly believed that his strategy stillmade tremendous sense in the long run and that he shouldcontinue following the same course as always. Unfortunately, his clients disagreed. The vast majority of themran for the exits, pulling their money away in large numbers, most likely to give it to a manager who, unlike myfriend, “knew what he was doing.”As you guessed, they should have stuck around. Thelast five or six years have been so good for my friend and
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his strategy that now the investment record of his firmsince its inception (once again, including those tough firstfew years) has trounced the returns of the major marketaverages over the comparable time frame. Today it standsamong the top of only a small handful of firms withextraordinary investment records out of the thousands ofinvestment firms on Wall Street. To prove that sometimesgood things do come to those who wait, my friend’s firmnow manages over $10 billion for hundreds of clients. Toobad that, in the face of several years of underperformance,most choose not to wait. Only four original clientsremain.*So what’s the point? The point is that if the magicformula worked all the time, everyone would probably useit. If everyone used it, it would probably stop working. Somany people would be buying the shares of the bargainpriced stocks selected by the magic formula that theprices of those shares would be pushed higher almostimmediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined!That’s why we’re so lucky the magic formula isn’tthat great. It doesn’t work all the time. In fact, it might*Luckily, I’m one of them! (Though, as his friend, I probably had to stickaround.)
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not work for years. Most people just won’t wait that long.Their investment time horizon is too short. If a strategyworks in the long run (meaning it sometimes takes three,four, or even five years to show its stuff), most peoplewon’t stick with it. After a year or two of performingworse than the market averages (or earning lower returnsthan their friends), most people look for a new strategy—usually one that has done well over the past few years.Even professional money managers who believe theirstrategy will work over the long term have a hard timesticking with it. After a few years of poor performancerelative to the market or to their competitors, the vastmajority of clients and investors just leave! That’s why it’shard to stay with a strategy that doesn’t follow along witheveryone else’s. As a professional manager, if you dopoorly while everyone else is doing well, you run the riskof losing all your clients and possibly your job!Many managers feel the only way to avoid that risk isto invest pretty much the way everyone else does. Oftenthis means owning the most popular companies, usuallythe ones whose prospects look most promising over thenext few quarters or the next year or two.Perhaps now you’re beginning to see why mosteveryone else won’t be using the magic formula. Thoughsome may take it out for a spin, most won’t last past thefirst few months or years of poor performance. As we
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discussed back in Chapter 1, you’re also beginning tosee why all that having to believe stuff is so important. Ifyou don’t believe that the magic formula will work foryou, you’ll most likely quit before it has a chance towork! At least, that’s where the statistics over the last17 years seem to point. The magic formula works—long-term annual returns of double, or in some casesalmost triple, the returns of the market averages—onlythose good returns can get pretty lumpy. Over shorterperiods, it may work or it may not. When it comes to themagic formula, “shorter” periods can often mean years,not days or months. In a strange but logical way, that’sthe good news.Good news, that is, if you believe enough in the magicformula to stick with it over the long term. But to trulystick with a strategy that hasn’t worked in years and years,you’re going to have to really believe in it deep down inyour bones. Sure, the spectacular track record of themagic formula will help, but let’s see what your bonesthink of the next chapter.
Quick Summary
1. The magic formula appears to work very well overthe long term.
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2. The magic formula often doesn’t work for severalyears in a row.3. Most investors won’t (or can’t) stick with a strategythat hasn’t worked for several years in a row.4. For the magic formula to work for you, you mustbelieve that it will work and maintain a long-terminvestment horizon.5. If it wasn’t for this chapter, the next chapter wouldbe the most important chapter in the book.
Chapter Nine
“VOMIT UNDER THE 3EM-SPACES AND RUN!”Now there’s a saying you don’t hear every day. Themain reason you don’t hear it much is pretty straightforward. Over time, the phrase has lost all of its meaning. Infact, I really only needed it to pass my eighth-grade coursein print shop.You see, old-time printers used to set type by handand actually picked letters individually out of a box. Topass the course, my fellow middle schoolers and I wereforced to memorize the location of these letters. The letters in the bottom row were V-U-T, then something calleda 3em-space, followed by the letters A-R. We remembered
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the order by the catchy phrase “Vomit under the 3emspaces and run!”With the advent of computers, my little memorydevice—and print shop, for that matter—is now useless.Of course, the world has changed a lot since I was in middle school. No one teaches print shop anymore. Thankfully, though, some subjects haven’t changed. Math class,for one, is still pretty much the same. As investors, that’sreally important to know.That’s because, in order for the magic formula tomake us money in the long run, the principles behind itmust appear not only sensible and logical, but timeless.Otherwise, there is no way we’ll be able to “hang on”when our short-term results turn against us. As simple asit may seem, knowing that two plus two always equals fourcan be a pretty powerful concept. No matter how manypeople tell us differently, no matter how long they tell us,and no matter how smart all those people appear to be, weare unlikely to waver in our conviction. In a similar way,our level of confidence in the magic formula will determine whether we can hang on to a strategy that may beboth unpopular and unsuccessful for seemingly long periods of time.So what is it about the magic formula that makessense—so much sense, in fact, that we won’t waver whenthings turn against us? Well, let’s take another look.
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The magic formula chooses companies through aranking system. Those companies that have both a highreturn on capital and a high earnings yield are the onesthat the formula ranks as best. Put more simply, the formula is systematically helping us find above-average companies that we can buy at below-average prices.That certainly sounds logical and sensible. If, indeed,that’s what we’re really doing, it also sounds like a strategy we can truly believe in. So, let’s go step-by-step andsee whether that’s true.First, why are companies that earn a high return oncapital so special? What kind of companies is our formulatelling us to buy? What makes them above average? Tounderstand the answers to those questions, let’s go backand check in with our old friend Jason.Last year, as you may remember, was a pretty goodyear for Jason’s business. Each of his gum shops earned$200,000. Since he only had to invest $400,000 to buildeach store (including inventory, store displays, etc.), thatmeant that his return on capital for opening a gum shopwas a pretty impressive 50 percent ($200,000 divided by$400,000). So what does that mean?Most people and most businesses can’t find an investmentthat will earn a 50 percent annual return. If the past year is agood guideline and Jason’s company can really earn 50percent a year on its money by simply opening another
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store, that makes Jason’s Gum Shops a pretty specialbusiness. Think about that. Having the opportunity toinvest your money and earn 50 percent per year is prettyrare. While it’s true that there is no guarantee thatJason’s new stores (or his old stores) will continue to earn50 percent returns each year on their original cost, lastyear’s high returns may be a good indicator of the opportunity to earn high returns from investing in that samebusiness going forward.If that’s true and Jason’s Gum Shops can continueto earn high returns from its investments in old and newstores, that’s really good news for Jason. First, that maymean that the profits from Jason’s business don’t have tojust sit there. While Jason’s Gum Shops could takethose earnings and invest in a government bond paying 6percent per year, they have a much better option. Thecompany can take those earnings and invest them in anew store. So not only will the original investment in thefirst store continue to earn 50 percent per year, butJason’s Gum Shops has the chance to invest the profitsfrom the first store in a new store that may also earn 50percent a year!This opportunity to invest profits at high rates of return isvery valuable. For example, if Jason’s Gum Shops earned$200,000 last year, Jason has a few options. He can distribute that money to the shareholders of the business (the
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shareholders can then invest that money however theychoose). If the business doesn’t change much this comingyear, Jason’s Gum Shops will earn $200,000 again. Thatmay be a fine outcome.But if, instead, Jason’s Gum Shops takes its $200,000in profits and invests them in government bonds paying 6percent (3.6 percent after taxes at a 40 percent rate), Jason’sbusiness will earn $207,200 this coming year ($200,000from the store and $7,200 in after-tax profits from intereston the bond). Though earnings would be higher than lastyear, the growth rate in earnings would not be very high.But here’s where the big bucks roll in. If Jason takesthat same $200,000 in profits and can invest it in a newstore that earns a 50 percent annual return,* the earningsfor Jason’s Gum Shops will grow to $300,000 in the coming year ($200,000 from the original store and an additional $100,000 from the investment in the new store).Going from $200,000 in earnings last year to $300,000 inthe coming year would represent a 50 percent earningsgrowth rate in one year!In other words, owning a business that has the opportunityto invest some or all of its profits at a very high rate of return cancontribute to a very high rate of earnings growth!*Assume for this example that we can invest in half a store (though a newstore costs $400,000).
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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 havethe opportunity to invest their profits at very high rates ofreturn. Since most people and businesses can invest theirmoney at only average rates of return, this opportunity issomething special. Second, as we just learned, the abilityto earn a high return on capital may also contribute to ahigh rate of earnings growth. Certainly, that’s good newsfor the companies chosen by the magic formula.But that still leaves us with one obvious question. If abusiness like Jason’s really can make 50 percent a year byopening a gum shop, why won’t other people see that andstart opening their own gum shops?That would mean more competition for Jason’s GumShops. More competition could mean that Jason will sellless gum in each of his stores. More competition couldmean that Jason must lower his prices to attract business.More competition could mean that someone builds a better gum shop. In short, more competition could meanlower profits going forward for Jason’s Gum Shops.In fact, that’s how our system of capitalism works.Good businesses attract competition. Even if competinggum shops open up and the return on capital from opening a new Jason’s gum store drops to 40 percent, thethreat to future profits might not end there. Earning 40
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percent annual returns from opening a gum shop is stillquite good. People might see those 40 percent annualreturns from opening a gum shop as very attractive anddecide to open their own gum shops. Then, due to theincreased competition, returns may fall all the way to 30percent per year from building a new gum shop.But even there it might not stop! Earning 30 percenta year on an investment is also good. More competitioncould continue to drive down future returns on capitalfrom new stores and from old stores that are already built.This whole capitalism thing could result in profits continuing to spiral downward until the annual returns on capital from owning gum stores isn’t so great anymore. Somesystem!But here’s the thing. If capitalism is such a tough system, how does the magic formula find us companies thatare able to earn a high return on capital in the first place?To earn a high return on capital even for one year, it’slikely that, at least temporarily, there’s something specialabout that company’s business. Otherwise, competitionwould already have driven down returns on capital tolower levels.It could be that the company has a relatively newbusiness concept (perhaps a candy store that sells onlygum), or a new product (like a hot video game), or a better product (such as an iPod that’s smaller and easier to
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use than competitors’ products), a good brand name(people will happily pay more for Coke than for Joe’sCola, so Coke can charge more than Joe’s and continueto earn a high return on capital despite having competition), or a company could have a very strong competitiveposition (eBay was one of the first auction web sites andhas more buyers and sellers than anyone else, so it’shard for new auction sites to offer the same benefits tocustomers).In short, companies that achieve a high return on capitalare likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability toearn above-average profits.Businesses that don’t have anything special going forthem (such as new or better products, well-known brandnames, or strong competitive positions) are likely to earnonly average or below-average returns on capital. If there’snothing special about a company’s business, then it’seasy for someone to come in and start a competing business. If a business is earning a high return on capital andit’s easy to compete, eventually someone will! They’llkeep competing until returns on capital are driven downto average levels.But the magic formula doesn’t choose companies withaverage returns on capital. It doesn’t choose companies
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with below-average returns on capital, either. (Businesseslike Just Broccoli are unlikely to earn a high return oncapital for even one year!)So by eliminating companies that earn ordinary or poorreturns on capital, the magic formula starts with a group of companies that have a high return on capital.Sure, some of the companies chosen by the magic formula won’t be able to maintain their high return on capital.As we just learned, businesses with high returns on capitaltend to attract competition. Also, even mediocre businesses can have a good year or two and temporarily achievea high return on capital.But, on average, the high-return-on-capital companieschosen by the magic formula are more likely to have theopportunity to reinvest a portion of their profits at highrates of return. They are more likely to have the ability toachieve high rates of earnings growth. They are also morelikely to have some special competitive advantage that willallow them to continue to earn an above-average return oncapital. In other words, on average, the magic formula is finding us good companies!And what does the magic formula do with this groupof good companies . . . ?It tries to buy them at bargain prices!
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The formula chooses only good companies that alsohave a high earnings yield. A high earnings yield meansthat the formula will buy only those companies that earn alot compared to the price we are paying.Hmmm . . . buying above-average companies at belowaverage prices, it sounds like it should work!But how do your bones feel about that?
Quick Summary
1. Most people and businesses can’t find investmentsthat will earn very high rates of return. A companythat can earn a high return on capital is thereforevery special.2. Companies that earn a high return on capital mayalso have the opportunity to invest some or all oftheir profits at a high rate of return. This opportunity is very valuable. It can contribute to a high rateof earnings growth.3. Companies that achieve a high return on capital arelikely to have a special advantage of some kind.That special advantage keeps competitors fromdestroying the ability to earn above-average profits.4. By eliminating companies that earn ordinary orpoor returns on capital, the magic formula starts
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with a group of companies that have a high returnon capital. It then tries to buy these above-averagecompanies at below-average prices.5. Since the magic formula makes overwhelmingsense, we should be able to stick with it duringgood times and bad.And finally,6. If you must vomit under the 3em-spaces, don’t forget to run!
Chapter Ten
I