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Magic Formula
- 1. Using the “Magic Formula” by Larry Holmes
- 6. There’s a crazy guy named Mr. Market
- 7. “… if you stick to buying good companies … and to buying those companies only at bargain prices … you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.” -- The Little Book That Beats The Market (p. 45)
- 8. Question: What’s a good business?
- 9. Question: What’s a good business? Answer: One with a high return on capital
- 10. Question: What’s a bargain price?
- 11. Question: What’s a bargain price? Answer: A business with a high earnings yield
- 12. Okay, so what’s the Magic Formula?
- 13. Return on Capital EBIT / (Net Working Capital + Net Fixed Assets)
- 14. Earnings Yield EBIT / Enterprise Value
- 15. “… what would happen if we decided to only buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield)?”
- 16. “ What would happen? Well, I’ll tell you what would happen… We would make a lot of money!” -- The Little Book That Beats The Market (p. 51)
- 17. From 1988-2004, “owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year.” -- The Little Book That Beats The Market (p. 52) Note: The S&P 500 index returned 12.4 percent per year
- 18. Question: Why will the Magic Formula continue to work after everybody knows about it?
- 19. Question: Why will the Magic Formula continue to work after everybody knows about it? Answer: Because it doesn’t always work
- 20. “ The magic formula portfolio fared poorly to the market averages in 5 out of every 12 months tested.”
- 21. “ For full-year periods, the magic formula failed to beat the market averages once every four years.”
- 22. “ For one out of every six periods tested, the magic formula did poorly for more than two year in a row.”
- 23. “ During those wonderful 17 years for the magic formula, there were even some periods when the formula did worse than the overall market for three years in a row!” -- The Little Book That Beats The Market (p. 70)
- 24. Step 1
- 26. Step 3 Follow the instructions to get a list of the best businesses selling at a bargain price
- 29. Step 4 Buy five to seven of the top-ranked companies Note: Smaller accounts may want to use brokers like foliofn.com
- 30. Step 5 Repeat Step 4 every two to three months. After nine or ten months you should have a portfolio of 20 to 30 stocks
- 31. Step 6 Sell each stock after holding it for one year. Use the proceeds to buy more Magic Formula stocks according to Step 4
- 32. Step 7 Continue the process for many years Note: Don’t even think about evaluating performance for at least three to five years
- 33. Step 8 Send Joel Greenblatt a note and say thank you!