LOVE SAILING.I’m not very good at sailing.I know this, not just from the fact that my wife andkids are scared to go with me, but from hard experience. Once, through a slight miscalculation of wind andwater speed, I was 20 feet away from being slammed bya barge at least three football fields long. I rememberthis quite well, because I had my wife as a passenger(who hates boats anyway) while I was busy pulling thestarter cord on my little five-horsepower outboardengine (darn thing never works when you really need it)as the giant barge blasted its horn for me to get out ofthe way.
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Usually sailboats have the right of way over motorboats, but since 9-billion-pound barges don’t steer all thatquickly, the right-of-way thing gets switched around (goodto keep in mind if it ever comes up). So there I was,repeatedly pulling the worthless starter cord while tryingto act like I had everything under control (just so mywife’s last words wouldn’t be “I hate this stupid boat!”),when a final puff of wind helped us sail out of danger.I’m recounting this story not because I enjoy sailingalone. I actually like having company (preferably brave orblind company). I’m telling you this because even thoughI’m clearly not a good sailor, I still love sailing. And that’sthe same way many people feel about investing in the stockmarket. They may not be particularly good at it, or they maynot know whether they are any good at it, but there’s something about the process or the experience that they enjoy.For some of these people, investing by using a magicformula may take away some of that fun. I understandthis. There are also people who are good or would begood at picking individual stocks—without using a magicformula. And that’s fine, too. The next chapter shouldgive both groups an idea of what they’ll need to know ifthey want to be successful at picking stocks on their own.It should also show them how the principles behind themagic formula can still be used to guide individual investment decisions. But before even thinking about whether
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to go forward investing with or without the magic formula, there are still a few more things you should know.First, the magic formula has a better track recordthan I’ve been letting on. I didn’t reveal this good newsearlier for a reason. A good track record is not why youshould want to follow the magic formula. A good trackrecord is not why you will have good results in the future.A good track record is not why you will keep following themagic formula even when results turn against you. Thetruth is that a good track record only helps once youunderstand why the track record is so good. Now that youdo—simply put, the magic formula makes perfect sense—I cantrust you not to get carried away with a little more goodnews.As you recall, the magic formula was tested over arecent 17-year period. A portfolio of approximately 30stocks selected by the magic formula was held throughoutthat time, with each individual stock selection held for aperiod of one year. Performance was then measured over193 separate one-year periods.* The stock portfolios*Performance was measured from January 1988 to January 1989, then February 1988 to February 1989, then March 1988 to March 1989, and so on,for 193 one-year periods ending December 31, 2004. This is commonlyreferred to as 193 rolling one-year periods. Measuring three-year rollingperiods would mean measuring performance from January 1988 to January1991, February 1988 to February 1991, and so on.
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chosen by the magic formula usually beat the market averages, but there were one-, two-, and even three-year-longperiods when this was not the case. This created the riskthat investors might give up on the formula before it hada chance to work its magic.As we discussed, over one-year periods, the magicformula stock portfolios underperformed the market averages in one out of every four years tested. Following theformula for any two-year period in a row (starting with anymonth during the 17 years), the magic formula underperformed the market averages in one out of every six periods tested. Remember, while that may not sound all thatbad, underperforming for two years in a row is actuallypretty hard to take! But here comes the good news. Following the formula for any three-year period in a row, themagic formula beat the market averages 95 percent of thetime (160 out of 169 three-year periods tested)!*But that’s not all! Over three-year periods, if you followed the magic formula, you would never have lostmoney. That’s right. Sticking with the magic formula forany three-year period during those 17 years, you wouldhave made money 100 percent of the time (169 out of 169*There are fewer three-year periods tested than one-year periods becausethe last three-year period that could be tested started in January 2002 andended December 31, 2004. The last one-year period started in January2004.
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three-year periods).* Of the 169 separate three-year periods tested, the worst return for the magic formula was again of 11 percent. The worst return over a three-yearperiod for the market averages was a loss of 46 percent.That’s a pretty big difference!But that’s still not all. All those numbers you just readabout were based on the results achieved by choosingfrom only the largest 1,000 stocks (those with a marketvalue over $1 billion). The results from choosing from thelargest 3,500 stocks (market values over $50 million), agroup of stocks individual investors can generally buy,were even better. Every three-year period tested (169 of169) was positive for the magic formula portfolios, andevery three-year period beat the market averages (169 outof 169). That’s right. The magic formula beat the marketaverages in every single period! Hey, maybe there is something to this magic formula, after all!†But can we really expect such great results withouttaking much risk? Well, the answer often depends on howyou choose to look at risk.‡ Although over the last 50*In other words, during our 17-year test period, the magic formula portfolios were still profitable even when they didn’t beat the market.†With this group of 3,500 companies, the worst three-year return for themagic formula portfolios was a gain of 35 percent. For the market averages,the worst three-year return was a loss of 45 percent!‡Though, in this case, the magic formula looks pretty darn good no matterhow we choose to measure risk.
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years professors in the financial field have come up withinteresting ways to measure or compare the risks of different investment strategies, most of these involve measuring risk in a way that should have no meaning to you.This is true especially if you choose to invest with a trulylong-term time horizon. When thinking about risk, ratherthan making things unnecessarily complicated, there arereally two main things you should want to know about aninvestment strategy:1. What is the risk of losing money following that strategyover the long term?2. What is the risk that your chosen strategy will performworse than alternative strategies over the long term?So how does the magic formula stack up under thisdefinition of risk? Since it is fairly easy to design an investment strategy to equal the return of the market averages*(and yet, as we’ll discuss later, most professional investorsdo even worse than the market averages), we can, at thevery least, make a reasonable comparison of these twosimple strategies. So let’s see.During our test period and using even a relativelyshort three-year time frame, the magic formula strategy*Such as an investment in an index fund or an exchange-traded fund (ETF).
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did pretty darn well. The returns from the magic formulastrategy were far superior to the returns of the marketaverages. The magic formula strategy never lost money.*The magic formula strategy beat the market averages overalmost every single three-year period tested. In short, themagic formula strategy achieved better results with less riskthan the market averages.Though sticking with the magic formula strategy foreven three years paid off incredibly well during our testperiod, this may not always be the case. Even superiorinvestment strategies may take a long time to show theirstuff. If an investment strategy truly makes sense, thelonger the time horizon you maintain, the better yourchances for ultimate success. Time horizons of 5, 10, oreven 20 years are ideal.Though not easy to do, even maintaining a three- tofive-year horizon for your stock market investments shouldgive you a large advantage over most investors. It is alsothe minimum time frame for any meaningful comparison ofthe risks and results of alternative investment strategies.We now have a better understanding of just how powerful and low risk the magic formula truly is, but we still*The market averages lost money in 12 percent of the three-year periodstested. Of course, despite the 100 percent success rate of the magic formuladuring the test period, it is almost certain that the magic formula strategy willhave negative performance periods in the future.
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have one problem left to solve before we can move on tothe next chapter. It has to do with our old friend Mr. Market, and maintaining a proper time horizon plays a keyrole here, too.As you may recall from the first day of businessschool in Chapter 4, it is Mr. Market’s constantly changing emotional state that creates the bargain opportunitiesthat the magic formula is able to put to its advantage. Butthese same emotions create a problem. If Mr. Market isso unstable, how can we be sure that he will eventually paya fair price for our bargain purchases? If we don’t eventually get a fair price from Mr. Market, a bargain couldremain a bargain forever (or worse, become even more ofa bargain!).So here’s the other thing you need to know about Mr.Market:• Over the short term, Mr. Market acts like a wildly
emotional guy who can buy or sell stocks at depressedor inflated prices.• Over the long run, it’s a completely different story:Mr. Market gets it right.Yep. Over the long term, crazy Mr. Market is actuallya very rational fellow. It may take a few weeks or a fewmonths, and not infrequently a few years, but eventually
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Mr. Market will pay a fair price for our shares. I actuallygive a guarantee to my MBA students at the beginning ofeach semester. I guarantee them that if they do a good jobvaluing a company, Mr. Market will eventually agree withthem. I tell them that, though it can occasionally takelonger, if their analysis is correct, two to three years isusually all the time they’ll have to wait for Mr. Market toreward their bargain purchases with a fair price.How can this be? Isn’t Mr. Market an emotional basket case? Well, although it’s true that Mr. Market canoften be ruled by emotion over the short term, over timefacts and reality take over. If the price of a stock has beenbeaten down unfairly in the short term by an overly emotional Mr. Market (this could happen, for instance, whena company announces some bad news or is expected toreceive some bad news in the near future), a few thingscan take place.First, there are a lot of smart people out there. If theprice offered by Mr. Market is truly a bargain, some ofthese smart people will eventually recognize the bargainopportunity, buy stock, and push the price closer to fairvalue. This doesn’t have to happen right away. Sometimesuncertainty about the prospects for a particular companyover the near term will keep potential buyers away. Sometimes the influence of emotions can last for years. Buthere’s the thing. Eventually, the problem or the reason for
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the emotional reaction is resolved. It could be a positiveresolution or a negative one. It doesn’t really matter. Ifthere is uncertainty about a company’s earnings over thenext two or three years, by waiting long enough we eventually find out the answer (even if this takes the full two orthree years!). Once the reality of the situation is known,smart investors will buy stock if the bargain opportunitystill exists.Second, even if these so-called “smart” people don’trecognize the bargain opportunity and buy shares, thereare other ways that stock prices can move toward fairvalue. Often companies buy back their own shares. If acompany believes its shares are undervalued, the management of the company can decide that it is a good investment to use its own cash and repurchase some of thecompany’s shares.* So this action of companies buyingback their own shares is another activity that causes pricesto rise and may help eliminate some bargain opportunities.If that doesn’t work, there are still other ways thatshare prices tend to move toward fair value. Remember, ashare of stock represents an ownership interest in anactual company. Anyone who buys all of the shares*This would reduce the amount of cash the company had, but it would alsoreduce the number of shares outstanding of the company. If ownership ofthe company is distributed among fewer shares, each remaining shareholderwould own a larger percentage interest in the company.
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outstanding would then own the entire company. Often, ifa bargain opportunity persists for too long, another company or a large investment firm may decide to make a bidfor all of the shares outstanding and purchase the entirecompany. Sometimes even the possibility that a buyer forthe whole company may emerge can cause share prices torise toward fair value.In short, over time the interaction of all of thesethings—smart investors searching for bargain opportunities, companies buying back their own shares, and thetakeover or possibility of a takeover of an entire company—work together to move share prices toward fairvalue. Sometimes this process works quickly, and sometimes it can take several years.Although over the short term, Mr. Market may set stockprices based on emotion, over the long term, it is the value of thecompany that becomes most important to Mr. Market.This means that if you buy shares at what you believe to bea bargain price and you are right, Mr. Market will eventuallyagree and offer to buy those shares at a fair price. In otherwords, bargain purchases will be rewarded. Though the processdoesn’t always work quickly, two to three years is usually enoughtime for Mr. Market to get things right.So now that we have all that good news out of the way,let’s see if we can sail through the next chapter withouthitting anything.
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Quick Summary
1. The magic formula works. It works even betterthan I let on before.2. The magic formula achieved its far superior resultswith far less risk than the market averages.3. Although over the short term Mr. Market mayprice stocks based on emotion, over the long termMr. Market prices stocks based on their value.4. If you couldn’t vomit under the 3em-spaces, trysailing with me.
Chapter Eleven
SO THE MAGIC FORMULA ISN’T YOUR THING. The high returns,the low risk, the simplicity, the logic—these things meannothing to you. You want—in fact, you need—to pick stocksall by yourself! No one, and especially no silly formula, isgoing to stand in your way. You’re out there on the ledge,and there’s no use talking you down! Don’t worry. I get it,and that’s just fine. But to borrow from something I oncewrote, remember this:Choosing individual stocks without any idea of what you’relooking for is like running through a dynamite factory with aburning match. You may live, but you’re still an idiot.
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So how can you pick stocks intelligently? What shouldyou be looking for? Even if you’ve decided not to followthe magic formula, how can you still use it to keep fromblowing yourself up? Well, glad you asked. Let’s see.As we already know, the magic formula picks stocks thathave both a high earnings yield and a high return on capital.For earnings yield, the formula looks for companies thatearn a lot compared to the price we have to pay. For returnon capital, the formula looks for companies that earn a lotcompared to how much the company has to pay to buy theassets that created those earnings. To calculate these ratios,the magic formula doesn’t look at future earnings. That’stoo hard. The magic formula uses last year’s earnings.The funny thing is, that seems like the wrong thing todo. The value of a company comes from how much moneyit will earn for us in the future, not from what happenedin the past. If a company earned $2 per share last year,but will earn only $1 per share this year and even less inthe future, using last year’s earnings to calculate earningsyield and return on capital will be very misleading. Butthat’s precisely what the magic formula does!In fact, often the near-term prospects for the companies selected by the magic formula don’t look so good. Inmany cases, the outlook for the next year or two is downright ugly. But that’s one reason the magic formula can
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find companies whose prices seem like bargains. Themagic formula uses last year’s earnings. If, instead, estimates for this year’s or next year’s earnings were used,many of the companies selected by the magic formulamight not look like such bargains at all!So what should we be doing? Ideally, better than blindlyplugging in last year’s earnings to the formula, we should beplugging in estimates for earnings in a normal year.* Ofcourse, last year’s earnings could be representative of a normal year, but last year may not have been typical for a number of reasons. Earnings could have been higher thannormal due to extraordinarily favorable conditions that maynot be repeated in most years. Alternatively, there may havebeen a temporary problem with the company’s operations,and earnings may have been lower than in a normal year.Plugging in estimates for next year’s earnings to our formula may suffer from the same problem. Next year may notbe typical. So one solution might be to look ahead even further to our estimates of what earnings will be three or fouryears from now in a normal or average environment. Shortterm issues that may have affected last year’s earnings orthat may affect earnings over the next year or two couldthen largely be eliminated from our thinking.*A normal year is one in which nothing extraordinary or unusual is happening within the company, its industry, or the overall economy.
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In this ideal world, we would then be able to take ourestimates of normal earnings and calculate earnings yieldand return on capital. Using the principles of the magicformula, we could look for companies that had both ahigh earnings yield and a high return on capital based onnormal earnings. Of course, we would also need to assesshow confident we were in our estimates and make a judgment on whether those earnings were likely to grow in thefuture.* We could then compare the earnings yield basedon normal earnings to a risk-free 6 percent governmentbond and to our other investment opportunities.Does that sound hard to do? Well, it is. Yet it’s notimpossible. There are people who can do this type ofanalysis. In fact, this is precisely the way my partners andI use the principles behind the magic formula to make ourown investment decisions. But if you can’t do this type ofanalysis (and here comes the main point of this chapter):You have no business investing inindividual stocks on your own!That’s right. Forget about it!But wait a second. The magic formula does prettywell, and it just uses last year’s earnings. It doesn’t make*As well as whether there was an honest management team that would reinvest those profits wisely.
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any estimates, and it doesn’t even do any thinking. Howcome the magic formula gets to pick stocks and I’mtelling most of you to just forget about picking individualstocks on your own?Well, the answer is that the magic formula doesn’tpick individual stocks, either. It picks many stocks at onetime. Looking at a whole portfolio of stocks, it turns outthat using last year’s earnings is often a good indicator ofwhat earnings will look like in the future. Of course, forindividual companies, this may not be the case. But onaverage, last year’s earnings will often provide a prettygood estimate for normal earnings going forward.That’s why, if we actually use the magic formula, we’llwant to own 20 or 30 stocks at one time. In the magic formula’s case, we want the average (that is, the averagereturn for a portfolio of stocks chosen by the magic formula). Since average results for the magic formula will,hopefully, mean extraordinary investment returns, owningmany different stocks chosen by the magic formula shouldhelp ensure that we stay pretty close to that average.By now, I hope I’ve convinced 99 percent of you tojust stick with the magic formula. But for those few whostill hope to develop a winning strategy for picking individual stocks, there is something that you should consider.Even professional research analysts and money managershave a tough time making accurate earnings predictions
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for individual companies. For these professionals, makingaccurate predictions for 20 or 30 companies at the sametime is even harder. It won’t be any easier for you.So here’s my suggestion. If you still want to buy individual stocks despite all the warnings, don’t even try tomake a lot of predictions. Limit your stock investments toa small number of “good” companies that are available atbargain levels. For those few investors who are capable ofestimating normal earnings several years into the futureand placing values on businesses, owning just a handful ofbargain-priced stocks is the best way to go. As a generalrule of thumb, if you are truly doing good research andhave a good understanding of the companies that you purchase, owning just five to eight stocks in different industries can safely make up at least 80 percent of your totalportfolio.*But what if you aren’t an expert at valuing businessesand making predictions? Isn’t there still some way you canintelligently play the stock-picking game? While it maynot be smart to hang out in dynamite factories, so what?Some people would rather have a blast. Well, okay. Thereis a compromise strategy, and it makes sense, too. Butyou’re still going to need the magic formula—there’s justno way around that (not in this book, anyway).*Not sure that makes sense? See the box at the end of the chapter!
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Here it is. Rather than just blindly choosing stocksthat catch your fancy or blindly accepting the output ofthe magic formula, how about combining both strategies?Start with the magic formula and put together a list oftop-ranked stocks. Then choose a few of your favorites bywhatever method you want. You must, however, choosesolely from the top 50 or 100 stocks as ranked by themagic formula.* Using this method, you should still placeat least 10 to 30 stocks in your portfolio (the lower end ofthis range if you actually know something about evaluating businesses and the higher end if you are choosingstocks based on birth signs). And that should do it.Now for the summary:1. Most people have no business investing in individualstocks on their own!2. Reread summary point number 1.3. But if you must . . . and you can actually predict normalized earnings several years down the road, usethose estimates to figure out earnings yield andreturn on capital. Then, use the principles of themagic formula to look for good companies at bargainprices based on your estimates of normal earnings.*Don’t worry, we’ll learn how to easily compile a list of top-ranked stockslater.
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4. If you truly understand the business that you ownand have a high degree of confidence in your normalized earnings estimates, owning five to eightbargain-priced stocks in different industries can bea safe and effective investment strategy.5. Most people have no business investing in individualstocks on their own! (Did I already mention that?)
How can owning just five to eight stocks possibly bea safe strategy? Think of it this way.* You’re a successful local businessman who has just sold off hisbusiness for $1 million. You want to invest that moneywisely so that you can safely earn a good return overtime. You have the opportunity to reinvest the proceeds from the sale of your business by buying anownership stake in some of the other businesses intown. You have some understanding of about 30 ofthose businesses, and your plan is to invest in companies that you understand well, that have a goodfuture, and that are available at a reasonable price.For those companies about which you feel mostconfident in your ability to make predictions, youproject what normal earnings should be several years*To borrow an analogy from one of the world’s greatest investors.
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down the road. You also look for companies that youbelieve will be able to continue in business for manyyears and for companies that should have the abilityto grow their earnings over time. Then you calculateearnings yield and return on capital based on yourestimates for each of those companies. Of course,your goal is to find good businesses that can be purchased at bargain prices. On the basis of your analysis, you select your five favorites and invest $200,000in each.Does that sound like risky behavior? It would beif you had no idea how to read financial statements orevaluate individual businesses. But if you do have thatability, is buying a stake in your five favorite businesses enough? Would owning a stake in your eightfavorites be better? I think most people, especiallythose who view stocks as long-term ownership stakesin actual businesses, would think that spreading that$1 million among investment stakes in five to eightbargain-priced businesses in varying industries wouldqualify as prudent behavior.At least, that’s the view I take with my investmentportfolio. The more confidence I have in each one ofmy stock picks, the fewer companies I need to own in
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my portfolio to feel comfortable. Most investors viewstocks and the construction of stock portfolios differently, however.Somehow, when ownership interests are dividedinto shares that bounce around with Mr. Market’smoods, individuals and professionals start to thinkabout and measure risk in strange ways. When shortterm thinking and overly complicated statistics getinvolved, owning many companies that you know verylittle about starts to sound safer than owning stakes infive to eight companies that have good businesses,predictable futures, and bargain prices. In short, forthe few who have the ability, knowledge, and time topredict normal earnings and evaluate individualstocks, owning less can actually be more—more profits, more safety . . . and more fun!
Chapter Twelve
THERE’S SOMETHING ABOUT THE TOOTH FAIRY. For some reason, I’ve never been able to fully fess up to my kids aboutwhat’s really going on there. Perhaps I just want them tohold on to their childhood for as long as possible, ormaybe I just want to cherish the innocence of that stage oftheir lives. But whatever it is, I’ve been a rock while underthe most intense of interrogations concerning my whereabouts after money has mysteriously appeared under thevarious pillows in question.I’ve had a few close calls, though. I thought the jigwas up one day when one of my kids marched home fromfirst grade with some new information (it’s scary the kindof things they pick up hanging out in the school yard). It
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seems a friend, with absolutely no regard for all my yearsof stonewalling, had spilled the beans. As I was doing allI could to choke back my disappointment, my miniatureSherlock Holmes declared, “I know who the tooth fairyis!” My mind raced for some way out as he continued,“It’s Billy Gordon’s mother!”After explaining what a ridiculous logistical and financial nightmare it would be for Billy Gordon’s mother toroam the entire world each night collecting teeth andshelling out money, I was able to quell that particular pieceof misinformation. And luckily, either because of a lack ofinvestigative instincts or merely because they have learnedto humor me over the years, that’s the closest any underage member of my house has come to cracking the case.But here’s a secret I have no problem divulging. Inmy house, whatever story my kids choose to believe is justfine with me. But in the stock market, there’s only oneversion of the story I want them to know. It’s harsh andit’s unfair, but we all have to grow up sometime. And it’sabout time you know it, too. So here it is. When it comesto Wall Street,There ain’t no tooth fairy!**Of course, since technically that’s a double negative, I still haven’t admitted anything!
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That’s right. On Wall Street, money won’t magicallyappear under your pillow. There’s no one to tuck you in,no one to take care of you, and no one you can turn to forgood advice. Once you’ve left the warmth and comfort ofyour own home, the plain fact is, you’re on your own.To see why this is necessarily so, we’re going to takeour own little walk down Wall Street. But before we setout, let’s make a few assumptions. First, you have somemoney that you would like to invest over the long term.(Long term, in this case, means that you will not need thismoney to cover your normal expenses for at least the nextthree to five years—and, hopefully, longer.)* Second, youwould like to earn as much as possible from your investments, but you are unwilling to take unreasonable risks.Finally, you’ve heard (and this is generally true) that thestock market offers the best possibility for high investment returns over time, and this is where you would liketo put most of your money. So, fine, where do we start?Well, one typical stop is our friendly neighborhoodstockbroker. This is an investment professional whose job isto hold your hand and help you invest your money. Your*Since Mr. Market can do anything in the short term, money that yourequire over the next few years for necessities is best left in the bank. Otherwise, you may be forced to sell to Mr. Market at just the wrong time (forinstance, when you need money to cover expenses and a depressed Mr. Market is offering low prices for your shares).
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stockbroker will help you choose between individualstocks, bonds, investment funds, and various other investment alternatives. If you have enough money, he or shewill even speak with you on the phone, try to understandyour needs, and give you suggestions and advice.But here’s the thing. If your stockbroker is like thevast majority, he or she has no idea how to help you! Mostget paid a fee to sell you a stock or a bond or