Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

  • Suppose you figured that a business (perhaps one like Jason’s Gum Shops) was worth between $10 and $12 per share, and at varying times during the year, its shares could be purchased for between $6 and $11. Well, if you were confident about your estimate of what the business was worth, then deciding whether to buy shares when they were trading near $11 might be a difficult decision. But when shares in that same company during that same year were available at close to $6, your decision might well become much easier!

  • Graham referred to this practice of buying shares of a company only when they trade at a large discount to true value as investing with a margin of safety. The difference between your estimated value per share of, say, $70 and the purchase price of your shares of perhaps $37 would represent a margin of safety for your investment. If your original calculations of the value of shares in a company like General Motors were too high or the car business unexpectedly took a turn for the worse after your purchase, the margin of safety in your original purchase price could still protect you from losing money.

  • By looking at the income statement that Jason had provided us, it turned out that Jason’s chain of 10 gum shops had earned a total of $1.2 million last year—pretty impressive. Since Jason had divided his business into 1 million equal shares, we had concluded that each share was therefore entitled to $1.20 in earnings ($1,200,000 divided by 1,000,000 shares). At Jason’s asking price of $12 for each share, that meant that based on last year’s earnings, Jason’s Gum Shops would have given us a 10 percent return for each $12 share purchased ($1.20 divided by $12 = 10 percent). That 10 percent return, calculated by dividing the earnings per share for the year by the share price, is known as the earnings yield. We then compared the earnings yield of 10 percent we could receive from an investment in Jason’s business with the 6 percent return we could earn risk free from investing in a 10-year U.S. government bond. We concluded, without too much trouble, that earning 10 percent per year on our investment was better than earning 6 percent. We then compared the earnings yield of 10 percent we could receive from an investment in Jason’s business with the 6 percent return we could earn risk free from investing in a 10-year U.S. government bond. We concluded, without too much trouble, that earning 10 percent per year on our investment was better than earning 6 percent. All things being equal, if you could buy a share of Jason’s Gum Shops for $12, which of those earnings results would you prefer? Would you prefer that Jason’s Gum Shops had earned $1.20 per share last year, $2.40 per share last year, or $3.60 per share last year? In other words, would you prefer that the earnings yield calculated using last year’s earnings was 10 percent, 20 percent, or 30 percent? Drumroll, please. If you answered that 30 percent is obviously better than 20 percent and 10 percent, you would be correct! And that’s the point—you would rather have a higher earnings yield than a lower one; you would rather the business earn more relative to the price you are paying than less! If we found out that it cost Jason $400,000 to build each of his gum stores (including inventory, store displays, etc.) and that each of those stores earned him $200,000 last year. That would mean, at least based on last year’s results, that a typical store in the Jason’s Gum Shops chain earns $200,000 each year from an initial investment of only $400,000. This works out to a 50 percent yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build sounds like a pretty good business.

  • Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.

  • Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital. Buying good businesses at bargain prices is the secret to making lots of money.

  • Over the last 17 years, 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. Investing at that rate for 17 years, $11,000 would have turned into well over $1 million. During those same 17 years, the overall market averaged a return of about 12.3 percent per year. At that rate, $11,000 would still have turned into an impressive $79,000.

  • The magic formula starts with a list of the largest 3,500 companies available for trading on one of the major U.S. stock exchanges. It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500. Similarly, the company that had the 232nd best return on capital would be assigned a rank of 232. Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield. The company with the highest earnings yield is assigned a rank of 1, and the company with the lowest earnings yield receives a rank of 3,500. Likewise, the company with the 153rd highest earnings yield out of our list of 3,500 companies would be assigned a rank of 153. Finally, the formula just combines the rankings. The formula isn’t looking for the company that ranks best on return on capital or the one with the highest earnings yield. Rather, the formula looks for the companies that have the best combination of those two factors. So, a company that ranked 232nd best in return on capital and 153rd highest in earnings yield would receive a combined ranking of 385 (232 + 153). A company that ranked 1st in return on capital but only 1,150th best in earnings yield would receive a combined ranking of 1,151 (1,150 + 1).

  • We probably don’t want to buy all 30 stocks at once. To reproduce the results from our tests, we will have to work into our magic formula portfolio over the course of our first year of investing. That means adding 5 to 7 stocks to our portfolio every few months until we reach 20 or 30 stocks in our portfolio. Thereafter, as stocks in our portfolio reach the one-year holding mark, we will replace only the 5 to 7 stocks that have been held for one year.

  • Two ways of implementing magic formula of investing

    • Option 1: MagicFormulaInvesting.com
      • Step 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 most individuals, 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-ranked magic formula companies.
      • Step 4 Buy five to seven top-ranked companies. To start, invest only 20 to 33 percent of the money you intend to invest during 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 have invested all of the money you have chosen to allocate to your magic formula portfolio. After 9 or 10 months, this should result in a portfolio of 20 to 30 stocks (e.g., seven stocks every three months, five or six stocks every two months).
      • Step 6 Sell each stock after holding it for one year. For taxable accounts, sell winners after holding them a few days more than one year and sell losers after holding them a few days less than one year (as previously described). Use the proceeds from any sale and any additional investment money to replace the sold companies with an equal number of new magic formula selections (Step 4).
      • Step 7 Continue this process for many years. Remember, you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work!
    • Option 2: General Screening Instructions If using any screening option other than magicformula investing.com, you should take the following steps to best approximate the results of the magic formula:
      • Use Return on Assets (ROA) as a screening criterion. Set the minimum ROA at 25%. (This will take the place ofreturn on capitalfrom 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 earnings yield from the magic formula study.)
      • Eliminate all utilities and financial stocks (i.e., mutual funds, banks and insurance companies) from the list.
      • Eliminate all foreign companies from the list. In most cases, these will have the suffix “ADR” (for “American Depository Receipt”) after the name of the stock.
      • If a stock has a very low P/E ratio, say 5 or less, that may indicate that the previous year or the data being used are unusual in some way. You may want to eliminate these stocks from your list. You may also want to eliminate any company that has announced earnings in the last week. (This should help minimize the incidence of incorrect or untimely data.)
      • After obtaining your list, follow steps 4 and 8 from the magicformulainvesting.com instruction page.
  • The 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 the study in this book are described in more detail as follows:* 1. Return on Capital EBIT/(Net Working Capital + Net Fixed Assets) employed (Net Working Capital + Net Fixed Assets). This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons. Return on capital was measured by calculating the ratio of pre-tax operating earnings (EBIT) to tangible capital

  • The 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 the study in this book are described in more detail as follows:

    1. Return on Capital EBIT/(Net Working Capital + Net Fixed Assets) employed (Net Working Capital + Net Fixed Assets). This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons. Return on capital was measured by calculating the ratio of 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 that the information in the database was timely or complete were eliminated. Adjustments were also made for certain non-interest bearing liabilities. The study was structured so that an average of 30 stocks was held during the study period. Stocks with only limited liquidity were eliminated from the study. Market capitalizations were determined based on 2003 dollars. Both the number of companies in each decile as well as the number of companies in each market capitalization group fluctuated as the number of companies in the database varied during the study period. EBIT (or earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using operating earnings before interest and taxes, or EBIT, allowed us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels. For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed). Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business. Net working capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded from this calculation) but does not have to lay out money for its payables, as these are effectively an interest-free loan (short-term interest-bearing debt was excluded from current liabili-ties for this calculation). In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment. EBIT (or earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using operating earnings before interest and taxes, or EBIT, allowed us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels. For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed). Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much capital is actually needed to conduct the company’s business. Net working capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded from this calculation) but does not have to lay out money for its payables, as these are effectively an interest-free loan (short-term interest-bearing debt was excluded from current liabilities for this calculation). In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment.

    2. Earnings Yield EBIT/ Enterprise Value. Earnings yield was measured by calculating the ratio of pre-tax operating earnings (EBIT) to enterprise value (market value of equity + net interest-bearing debt). This ratio was used rather than the more commonly used P/E ratio (price/earnings ratio) or E/P ratio (earnings/price ratio) for several reasons. The basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business.

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