some otherinvestment product. They don’t get paid to make youmoney. Of course, while it’s in their interest for you to besuccessful and many may be fine, well-intentioned professionals, a stockbroker’s main incentive is still to sell yousomething. They are trained to follow rules, understandcertain financial terms, and explain various investmentproducts. As for how to make you money in the stockmarket or anywhere else, forget it!You might as well just put your money in a mutual fund.Now here’s the perfect solution for a small investor. Amutual fund is an investment fund that is managed by a professional money manager. The manager usually selects adiverse group of stocks or bonds, generally from 30 to 200different securities in the same fund. This is a particularlyefficient way for a small investor to spread his or her investment capital over a wide group of different investments.But here, too, there are some problems. As we’ve discussed before, it’s tough to have special insight into many
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different companies and investment securities. Consequently, owning dozens or even hundreds of positionsdoes not often lead to above-average returns. Then, ofcourse, there is the small matter of fees. Mutual fundmanagement companies need to charge a fee for their services. Basic math says that average returns minus feesequals below-average returns. Not surprisingly, after subtracting fees and other expenses, the vast majority ofmutual funds do not beat the market averages over time.But that’s okay. We can just look for mutual fundsthat have above-average managers. It should be relativelyeasy to tell whether a manager is above average simply bylooking at the fund’s track record. The only problem withthis strategy is that on average there is no relationshipbetween a fund’s good past investment record and itsfuture returns. Even companies whose business is to ratemutual funds have a poor record of determining whichfunds will perform well in the future.While there are many reasons for this, all of them aredifficult to resolve. Mutual fund management companiesget paid based on how much money is invested in eachfund. A fund with a successful track record will usuallyattract more money over time. It is usually in the fund’seconomic interest to accept this money. Once a fundgrows larger, it may be hard for the manager to continuewith the same strategy that led to the successful returns.
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A few good ideas may now be spread even thinner over alarger pile of money. If investment in smaller companies ispartially responsible for some of the success, this may nolonger be possible in a larger fund. Also, even talentedmanagers have bad stretches of investment performance(just like the magic formula). Conversely, bad managerscan have good stretches. Telling which is which, even overperiods of several years, is quite difficult. I could go on,but the facts are the facts. A good past investment recordisn’t much help when predicting future returns, and picking a good manager is likely no easier than picking attractive individual stocks. Then again, if you could pickattractive stocks, you probably wouldn’t need the goodmanager!So, instead, you might consider investing in a hedgefund. These are exclusive private investment funds usually reserved for very wealthy investors. Unfortunately, inmost cases, unless you already have at least $500,000 orso to invest, you probably won’t even have this option. Bylaw, most hedge funds can only accept investors who canafford to lose large amounts of money. But even if youqualify for this dubious honor, it’s not clear that this is asmart way to go.Hedge funds are investment funds that have moreflexibility than most mutual funds. Managers can use thefund’s capital and borrowed money to buy a large variety
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of securities. Generally, they are able to place bets onwhether stocks, other securities, or entire market averages will move up or down. Most mutual funds arerestricted to making money only when the securities theyown go up. A hedge fund’s ability to bet up or down overmany different securities, often with the aid of borrowedmoney, is seen as a big advantage over most standardmutual funds. It may be. But most hedge funds chargehuge fees—at least 1 percent of assets under managementplus a 20 percent share of the profits. No doubt attractedby the large fees, thousands of new hedge funds havebeen created over the past few years. Most will have nochance of justifying their fees. There just aren’t thatmany great managers, and your chances of finding oneare quite slim.So that’s why many people just choose to invest in anindex fund.* An index fund is a mutual fund that just triesto equal the overall market’s return, less a very small fee.These funds pick a market index (perhaps the S&P 500index of 500 large stocks or the Russell 2000 index, anindex that consists of 2,000 somewhat smaller stocks) andbuy all of the stocks in that particular index. Although*Or an exchange-traded fund (ETF), an index fund that trades similar to theway a stock trades.
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this strategy won’t help you beat the market, it will helpyou achieve returns that are at least close to the marketaverages.* Since, after taking into account fees and othercosts, most other investment choices leave you with muchlower returns than index funds, many people who havecarefully studied the issue have concluded that settling foraverage returns is actually a pretty good alternative. Infact, over the last 80 years, average returns from the stockmarket have meant returns of over 10 percent per year.Not too bad at all.But what if you want to do better than average? Thesimple truth is there’s no stop on our little walk that has ananswer for that one. That’s because it’s pretty much likeI told you before: On Wall Street, there is no tooth fairy.Once you leave home, you can put your money under aprofessional’s pillow, but chances are, when you wake up,all you’ll be left with is lousy performance.Of course, I know what you’re going to ask. Isn’tthere somewhere you can go? Something you can do?Someone you can turn to?*Also, if you are not investing using a tax-free retirement account and taxesare a concern for you, this strategy will minimize the amount of taxes youmust pay because index funds typically do not sell their stock holdingsunless a particular security is dropped from the index. This is usually lessthan 10 percent of the securities in the index in any one year.
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Well, it should come as no surprise that after 25 yearsin the investment business, I’ve been asked these samequestions many times. From time to time, I have been ableto recommend a particularly good mutual fund manageror an exceptional hedge fund manager. In all cases, thefunds in question have subsequently grown to many timestheir original size and the investment opportunity haslargely vanished in a rather short period of time. I havealso tried to help people by giving out an occasional stocktip. However, an occasional stock tip from me is not avery reliable or universally available long-term investmentstrategy.So I’m usually at a loss. If you want to do as little aspossible and you don’t mind doing average, an index fundcould be a fine choice. But if you are capable of analyzingbusinesses and willing to do a fair amount of work, selectively picking individual stocks can be a viable alternative.The only problem is that most people don’t have the timeor ability to analyze individual companies. As we discussed last chapter, if you don’t know how to evaluatebusinesses and project normal earnings several years intothe future, you have no business investing in individualstocks in the first place.So here’s the thing. As unbelievable as it may seem, ifyou truly want to beat the market, there really is only one
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good alternative left. After all we’ve been through, Iprobably don’t have to spell it out for you. But let’s justsay it rhymes with . . . bagic mormula.That’s right. Just like I promised earlier, by followingthe simple steps outlined at the end of this book, you canuse the magic formula to beat the market. You can achieveextraordinary long-term investment returns, and you canachieve those returns with low risk. By following step-bystep, you’ll know exactly where to go and what to do. Itwon’t even take much work—just minutes every fewmonths.But that’s not the hard part. The hard part is makingsure that you understand why the magic formula makessense. The hard part is continuing to believe that themagic formula still makes sense even when friends,experts, the news media, and Mr. Market indicate otherwise. Lastly, the hard part is just getting started, thoughI’ve tried to make that task as easy as possible.So, good luck. I truly believe that if you follow thelessons in this book, you will have a great deal of investment success. That’s what makes the next chapter soimportant. After all, if my calculations are correct, you’restill going to be left with a pretty big problem. I’m veryserious. I mean, what are you going to do with all thatmoney?
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Quick Summary
1. On Wall Street, there ain’t no tooth fairy!2. Nothing much rhymes with magic formula.3. Your step-by-step instructions for beating the market using the magic formula are coming right afterthe next chapter.
Chapter Thirteen
WHAT WOULD YOU DO IF YOU HAD A LOT OF MONEY? Ofcourse, I mean what would you do after taking care ofyour family and those close to you, after providing forretirement and the future of your loved ones, and afterputting some aside to buy a few luxuries along the way?What would you do?Actually, you may well have to answer that questionsomeday. But don’t worry. I’m not going to bore you witha pile of statistics. I’m not going to tell you about all themoney you could make by using the magic formula. I’mnot even going to discuss the whole idea of compound interest. That’s the one where you invest a relatively smallamount of money, earn a reasonable rate of return over
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time, continually reinvest all the earnings from those investments, and end up with a large amount of money. I’mnot going to talk about that.It’s really too bad, though. With the new rules forcontributing larger amounts of money to tax-advantagedretirement accounts, it would have been a good thing todiscuss. As it turns out, starting now and making the maximum allowable contribution to an IRA* for just the nextfew years, you could turn a relatively small amount ofmoney into a much larger amount. Obviously, with thetype of returns achieved by the magic formula in the past,this really could have meant a lot of money for you. But,unfortunately, we’re not going to discuss it.It’s truly a shame. By contributing just $28,000 intotal over the next six years (the maximum of $4,000 peryear in both 2006 and 2007 and then $5,000 per yearstarting in 2008 for four years†), your retirement accountcould have grown to over $325,000 at the end of 20 yearsand over $1.3 million after 30 years. That’s if you couldachieve an annual return on your investments of 15 percent. Of course, the past record of the magic formula issomewhat better than 15 percent per year, but it would beirresponsible to project some higher annual return far into*Either a traditional investment retirement account or a Roth IRA.†Thereafter making no further contributions of any kind.
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the future. That’s because picking a number like 20 percent per year would turn that initial $28,000* into$752,000 after 20 years and more than $4.3 million after30 years. At an astronomical rate like 25 percent per year(a return that is still lower than the past returns of one ofour portfolios of smaller magic formula stocks), that$28,000 would have become more than $1.6 million in 20years and over $13.4 million in 30 years.† But who’s reallycounting, and with numbers like that, thank heaven I hadthe good sense not to mention it.But I will say this. If you are still in middle school oreven high school and you are approached by anyone—andI mean anyone, no matter how fancy their scooter or howpersuasive their sales pitch—and they want you to purchase a single stick of gum for 25 cents, I have just threewords of advice:*From investing the maximum allowable $4,000 per year in an IRA over thenext two years and then the increased maximum of $5,000 per year for thefollowing four years equaling $28,000 over the six years.†It’s fascinating to note that if you had decided to contribute $5,000 peryear for the remaining 24 years of this 30-year period, rather than stoppingcontributions after just six years as we did in this example, your IRAaccount would have grown to approximately $16.5 million after 30 yearsversus the $13.4 million from just those six contributions. Had we decidedto talk about compound interest, the relatively smaller benefit from thoselast 24 contributions would have illustrated how truly important starting asearly as possible is to achieving the full benefits of compounding.
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Don’t do it!I say that not because at any moment you could beforced to stand in the corner with a wad of gum stuck toyour nose. I say that because if you understood how a wellinvested quarter could possibly turn into more than $200 bythe time you hit middle age,* you might not squander somuch money on a single stick of gum! You might not spendmoney on a lot of things. Instead, you might start thinkingabout saving money whenever possible and spending time figuring out a good way to invest it. That’s what I’m saying.Unfortunately, one thing I’m not saying is that usingthe magic formula for your investments going forward willguarantee results similar to the stellar performance of thepast. I can’t know that.† But I can say this:I believe that using the magic formula and the principlesbehind the magic formula to guide your future investments will*Twenty-five cents invested at a return of 25 percent a year for 30 yearswould get you more than $200. Of course, I’m not saying you would actually achieve this type of return (as you know, I would never say that).†Though, since the market averages returned roughly 12 percent per year(including dividends) during the course of our 17-year study and my bestguess for the market averages going forward is closer to 6 to 10 percent peryear, you may want to start by adjusting down your hopes and/or expectations for the future absolute results of using the magic formula by 3 or 4percent per year as compared to the results found in the study. But, onceagain, I can’t really know.
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remain one of your very best investment alternatives. I believethat if you are able to stick with the magic formula strategythrough good periods and bad, you will handily beat the marketaverages over time. In short, I believe that, even after everyoneknows the magic formula, your results will continue to be notonly “quite satisfactory,” but with a little luck, extraordinary.So, here’s the deal. If you do end up using the magicformula and if it helps you earn enough money that youfeel grateful for your good fortune, you might considerthis. In reality, all the time and effort put into stock market investing isn’t a very productive use of time. Usually,when you buy or sell shares in a publicly traded company,* you are merely buying from or selling to anothershareholder. In other words, the underlying company isnot involved. It receives nothing from the transaction.Many people argue that all this buying and sellingactivity is, nevertheless, quite useful. Through the buyingand selling of shares, these people would argue, an activemarketplace for the company’s shares is established. Theoretically, if a company needs additional money, it candecide to sell additional shares into this marketplace. Itcan use the proceeds to pay bills, build factories, orexpand in some other way. This is all true. Also, if Jason*A company that files its financial information with the government andwhose shares the general public may buy and sell.
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decides to expand his gum store chain from 10 stores to300, he can sell some shares in his new and growing business directly to the public and raise money for the expansion. Since the buyers of Jason’s Gum Shop shares knowthat there will be a marketplace for selling those sharesafter their initial purchase, Jason may have an easier timeraising money for his business. The people who see greatvalue in stock trading are right about this, too.I’m just not one of those people. Yes, it is nice to havea marketplace. In fact, it’s very important. It’s just thatmore than 95 percent of the trading back and forth eachday is probably unnecessary. The market would still befine without almost all of it. The market would certainlybe fine without your contribution.In fact, the first day of class each semester, I tell all ofmy MBA students that I’m about to teach them skills thathave limited value. It’s not that they won’t have the potential to make a lot of money from what they learn. It’s thatthere are probably higher and better uses for their timeand intellect. As a consequence, in exchange for teachingthem, I always ask my students to find some way to giveback.*So, for you, too, I hope this book and the step-by-stepinstructions that follow will help you reach all of your*For some more thoughts, see the box at the end of the chapter.
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investment goals. I strongly believe that it will. I also hopethat those investment goals will include using some ofyour good fortune to make a difference in those areas thatare important and have meaning to you.Good luck.
There are, of course, many worthwhile things to dowith your money in addition to caring for those nearand dear to you. Whether it involves supporting medical research, aiding the poor, promoting social justice, or supporting pretty much any worthy cause thatyou believe in, all would obviously be wonderfulchoices for your charitable dollars. But since thisentire book is about investing your money in placeswhere it can earn a high return on capital, I have oneadditional thought that you might consider.It is our education system that nurtures the entrepreneurs, scientists, engineers, technologists, andhigh-level workforce that help our economy grow andthrive. Over time, the performance of the stock market reflects this progress. Yet it is very clear that weare wasting much of our future potential. In almostevery major city in the United States, barely half ofentering public school ninth-graders end up graduat-
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ing from high school. Think about that for a moment.Undoubtedly, there are many reasons for this devastating waste, but the problems, whatever they mightbe, clearly cut across all grade levels. Many studentsenter the ninth grade already four and five grade levels behind.So how should we solve this problem? Obviously,teaching young people should be a top priority, andspending money to teach children the skills necessaryto become productive members of society should be agreat investment. Talk about a high return on capital!Just as obvious is that there are negative costs todoing a bad job—crime, drugs, and welfare, to namea few. So, how are we trying to solve this problem?Under capitalism, it would be pretty straightforward. If we were trying to fix a business like JustBroccoli, we would first try to change a few things.Maybe we would fire bad managers, hire better salespeople, or do some advertising, but eventually, ifresults didn’t improve, we would just close the stores.Under our system of capitalism, companies that can’tearn an adequate return on capital eventually go outof business. That’s very healthy. Instead of continually throwing money into investments that achieve
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poor returns, under capitalism money is systematically redirected into businesses that can make productive use of new capital. That’s how our economycontinues to grow and thrive over time.So how would you fix the public school system?First, you would try to make some changes. Youmight fire bad teachers, pay more for good teachers,remove bad principals, and at the end of the day,close bad schools. The money spent on the badschools would be redirected to schools (public or private) that could get a higher return on the capitalspent. Unfortunately, in the case of inner-city publicschools, the same problems have been going on forover 40 years and the “fixes” have been going on forjust as long!The difference is this. In capitalism, if the fixesdon’t work, the business closes. With public schools,this rarely happens. It’s almost impossible to fire badteachers, pay more for good teachers, or close badschools. In short, there are no penalties for poor performance, incentives for good performance, or consequences for running a poor business.As a result, money spent on bad teachers or badschools is almost never redirected to teachers or
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schools that can achieve higher returns on that capital! So if we want to apply what we have learned aboutcapitalism, any solutions, whether they involve publicschool reform, charter schools, or voucher programs,need to address these issues. Otherwise, we’ll bestuck with a Just Broccoli school system for a longtime to come!**If you have further interest, some web sites you might consider:successforall.net, alliance forschoolchoice.com, schoolachievement.org,democratsforeducationreform.org.
Step-by-Step Instructions
Here’s the big picture. As you know, the magic formulahas achieved excellent results in the past. So our goal is tocreate an easy-to-follow plan that will help reproducethose good results. But before we adopt any strategy, weneed to consider a few things.First, since the returns reported in this book werebased on holding a portfolio of roughly 30 stocksselected by the magic formula, we should make sure thatour plan includes holding at least 20 to 30 stocks at onetime. Remember, the magic formula works on average, soholding many stocks that are ranked highly by the magicformula should help keep us close to that average overtime.*Second, in our tests, each stock was held for a period*Obviously, if you are already good at analyzing businesses and doing yourown research and are merely using the magic formula as a guideline to findattractive individual stocks, these diversification rules do not apply to you.On the other hand, if you are doing a limited amount of work on individualstocks or no work at all (like most investors), diversifying with 20 or 30magic formula stocks is most definitely the right plan for you.
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of one year. Holding stocks for one year is still fine for taxfree accounts. For taxable accounts, we will want to adjustthat slightly. For individual stocks in which we are showinga loss from our initial purchase price, we will want to sell afew days before our one-year holding period is up. For thosestocks with a gain, we will want to sell a day or two after theone-year period is up. In that way, all of our gains willreceive the advantages of the lower tax rate afforded tolong-term capital gains (a maximum 15 percent tax rateunder federal guidelines for stocks held more than oneyear), and all of our losses will receive short-term tax treatment (a deduction against other sources of income thatotherwise could have been taxable at rates up to 35 percent). Over time, this minor adjustment can add significantly to our after-tax investment returns.Lastly, be aware that getting started will be the hardest part. We probably don’t want to buy all 30 stocks atonce. To reproduce the results from our tests, we willhave to work into our magic formula portfolio over thecourse of our first year of investing. That means adding 5to 7 stocks to our portfolio every few months until wereach 20 or 30 stocks in our portfolio. Thereafter, asstocks in our portfolio reach the one-year holding mark,we will replace only the 5 to 7 stocks that have been heldfor one year. If that’s a little confusing, don’t worry, stepby-step instructions are about to follow.Now that we have that settled, we need to discuss a
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few simple ways to find our magic formula stocks. Thereare many choices for screening packages to help us sortthrough the universe of available stocks, both Web-basedprograms and software programs that utilize the Web forupdates. Some of these options are available for free,while others can cost up to $99 per month or even more.Each has advantages and disadvantages based on ease ofoperation and the reliability, flexibility, and breadth ofdata sources. Most will generate a reasonable set of magicformula stocks if certain conditions are applied, which arediscussed below.One screening option was created specifically for thisbook, magicformulainvesting.com. The magicformulainvesting.com site is designed to emulate the returnsachieved in our study as closely as possible. This site iscurrently available for free. Step-by-step instructions forselecting stocks using magicformulainvest ing.com follow.Other options include, but are not limited to, thescreening packages available at businessweek.com, aaii.com, moneycentral.msn.com, powerinvestor.com, andsmartmoney.com. Though these sources are generally fine,and are available either for free or at a reasonable price, theyare not specifically designed to generate magic formulastocks. They will only give a rough approximation of themagic formula results because of differences both in the criteria the user can select and the underlying data sources.General screening instructions are available on each site.
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Option 1: MagicFormulaInvesting.comStep 1
Go to magicformulainvesting.com.Step 2
Follow the instructions for choosing company size (e.g.,companies with market capitalizations over $50 million,or over $200 million, or over $1 billion, etc.). For mostindividuals, companies with market capitalizations above$50 million or $100 million should be of sufficient size.Step 3
Follow the instructions to obtain a list of top-rankedmagic formula companies.Step 4
Buy five to seven top-ranked companies. To start, investonly 20 to 33 percent of the money you intend to investduring the first year (for smaller amounts of capital, lowerpriced Web brokers such as foliofn.com, buyandhold.com,and scottrade.com may be a good place to start).Step 5
Repeat Step 4 every two to three months until you haveinvested all of the money you have chosen to allocate to yourmagic formula portfolio. After 9 or 10 months, this should
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result in a portfolio of 20 to 30 stocks (e.g., seven stocksevery three months, five or six stocks every two months).Step 6
Sell each stock after holding it for one year. For taxableaccounts, sell winners after holding them a few days morethan one year and sell losers after holding them a few daysless than one year (as previously described). Use the proceeds from any sale and any additional investment moneyto replace the sold companies with an equal number ofnew magic formula selections (Step 4).Step 7
Continue this process for many years. Remember, you mustbe committed to continuing this process for a minimum of threeto five years, regardless of results. Otherwise, you will mostlikely quit before the magic formula has a chance to work!Step 8
Feel free to write and thank me.
Option 2: General Screening Instructions
If using any screening option other than magicformulainvesting.com, you should take the following steps to bestapproximate the results of the magic formula:
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• Use Return on Assets (ROA) as a screening criterion.
Set the minimum ROA at 25%. (This will take theplace of return on capital from the magic formula study.)• From the resulting group of high ROA stocks,screen for those stocks with the lowest Price/Earning (P/E) ratios. (This will take the place of earningsyield from the magic formula study.)• Eliminate all utilities and financial stocks (i.e., mutual funds, banks and insurance companies) fromthe list.• Eliminate all foreign companies from the list. Inmost cases, these will have the suffix “ADR” (for“American Depository Receipt”) after the name ofthe stock.• If a stock has a very low P/E ratio, say 5 or less, thatmay indicate that the previous year or the data beingused are unusual in some way. You may want to eliminate these stocks from your list. You may also wantto eliminate any company that has announced earnings in the last week. (This should help minimize theincidence of incorrect or untimely data.)• After obtaining your list, follow steps 4 and 8 fromthe magicformulainvesting.com instruction page.
Appendix
IMPORTANT NOTICE: This appendix is not required reading. To utilize the magic formula strategysuccessfully, you must understand only two basic concepts. First, buying good companies at bargain pricesmakes sense. On average, this is what the magic formula does. Second, it can take Mr. Market several yearsto recognize a bargain. Therefore, the magic formulastrategy requires patience. The information that follows in this section is merely additional commentaryon these two points.This appendix includes background informationabout the magic formula for those with a higher level ofunderstanding of financial statements. It also comparesthe logic and results of the magic formula strategy withother studies and methods that have demonstrated anability to beat the market.
The Magic FormulaThe magic formula ranks companies based on two factors:return on capital and earnings yield. These factors can be measured in several different ways. The measures chosen for thestudy in this book are described in more detail as follows:*1. Return on Capital
EBIT/(Net Working Capital + Net Fixed Assets)Return on capital was measured by calculating the ratioof pre-tax operating earnings (EBIT) to tangible capital*For purposes of the study, earnings-related numbers were based on the latest 12-month period, balance sheet items were based on the most recent balance sheet, and market prices were based on the most recent closing price.Utilities, financial stocks and companies where we could not be certain thatthe information in the database was timely or complete were eliminated.Adjustments were also made for certain non-interest bearing liabilities. Thestudy was structured so that an average of 30 stocks was held during thestudy period. Stocks with only limited liquidity were eliminated from thestudy. Market capitalizations were determined based on 2003 dollars. Boththe number of companies in each decile as well as the number of companiesin each market capitalization group fluctuated as the number of companiesin the database varied during the study period.
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employed (Net Working Capital + Net Fixed Assets).This ratio was used rather than the more commonly usedratios of return on equity (ROE, earnings/equity) or returnon assets (