In the previous posts we saw that investment in a winning accumulation plan can not be separated from a careful stock picking activity (choice of shares).
In this article we will introduce a stock picking technique borrowed from fundamental analysis, namely Joel Greenblatt’s methodology presented in his book “The Little Book That Beats the Market”.
Before continuing, we should say a few words about the author. Joel Greenblatt, in addition to teaching finance at the Columbia Business School in New York, is a founding member and partner of Gotham Capital.
“The Little Book That Beats the Market”
I think readers can agree that the title chosen by Greenblatt for his book leaves much to be desired. This is really a small book: small format, a hundred pages, a cover price that does not exceed 10 euros and an incredible value for money (nowadays it is a fashionable expression to use – value for money).
Greenblatt introduces the reader to fundamental analysis in an almost light-hearted way. He does this by conversing with one of his young children about Jason’s activity, a boy who sells gum every day at school. Before going to school, Jason buys 4 packs of chewing gum which he then sells individually to his classmates. Each package contains 5 pieces, costs 25 cents. Jason manages to earn $ 4 a day for 5 days a week.
The reader finds it hard to believe how the author, with a few simple logical steps, manages to define seemingly complex fundamental concepts of analysis. The tone is always colloquial and Greenblatt, with his conversations about Jason’s activity, continues to introduce other concepts to define his methodology for evaluating a business. Jason’s is in fact a business like any other and the same rules can also be applied to companies listed on the stock exchange.
The Magic Formula
Joel Greenblatt arrives to identify a mathematical formula that allows to identify those that he considers to be the best shares on the market in which to invest with a time horizon of one year. His intent is to select quality companies that can be purchased at a great price.
The formula he uses is called Magic Formula and takes into account the Earnings Yield (earnings per share / price) and the Return on the Capital (operating income / capital employed in the exercise of the activity).
The magic formula returns a number for each security with the clear advantage of being able to compare thousands of securities and choose the most promising ones.
From 1988 to 2004 (17 years) the top 10 US stocks returned 25% annual average returns.
The author has also made available a free tool with which to calculate the Magic formula: www.magicformulainvesting.com.
Beyond the names used for his creatures (the small book that beats the market, magic formula) Joel Greenblatt knows his business and has written an important part of the history of fundamental analysis. His ideas and his approach still appear current and valid today (buy valuable goods at a low price).