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Let's get started. Imagine there is an 11 year old boy named Jason who goes to school but also has a side business. He buys a pack of chewing gum every day for 25 cents, which contains five sticks. He goes to school and sells each stick for 25 cents. Simple, isn't it? One pack costs 25 cents. That makes him a total of $1.25.
Meaning a comfortable profit of $1 per pack. If he sells even four to five packs a day, it becomes a good amount of money. Now here comes an interesting question. If Jason offers to sell you half of his gum business, how much would you pay for it? You will calculate it, okay. 6 years of school are left.
Daily profit, weekly profit, yearly profit. Suppose half of the total profit in year 6 is $500. So would you give him $500 today? Off course not. What is the point of paying $1500 in the first place and getting back $500 and that too gradually over 6 years. The money is going today. So what is the true value of this business?
Maybe $450, $500, that's half the investment. Simply figure out what the actual value of a business should be based on its future earnings. And when you know this price, then buy that business at a price much lower than its actual value. But wait, you might think this sounds very easy. If a business is worth $1000, why would someone sell it for $500?
Very good question. And Believe It or Not is a place where businesses sell half price every day. The name of that place is Stock Market. Joe Greenblad, the author of this book, explains this and has also created a magic formula for it. This formula is simple. The logic behind this is very solid and with this you can easily beat the market and even the big professionals.
The risk is also less. But before using this formula, it is important to understand why it works. Look, when you have some savings, say $1000, you have a few options. First, you put it under the mattress. This plan is useless because years later it will still be $1000. Their value will further decrease due to inflation.
Second, you deposit it in the bank. The bank will give you interest like 5% per annum. In 5 years, your $1000 will become $76. Not bad. There is another option. You can lend money to the US government by buying bonds. It is considered the safest investment in the world. Suppose you are getting a return of 6% on 10 year government bond.
This means that you can earn 6% per annum for 10 years without taking any risk. So this 6% became our benchmark. Any investment that involves even a little risk should give a return higher than this 6%. Otherwise why are we taking the risk ? Will give money to the US Government. So now let's come to the last option.
Investing in businesses. When you buy a share of a company like Jasons Gum Shops, you are buying a small part of that business. This means that you are entitled to a small share of the future profits of that business. Suppose Jason Gum Shops earned a profit of $1.2 million last year and he has divided his company into $1 million shares.
This means each share earned $1.20. If Jason is selling a share for $1, your first year return is 10% (earn $1.20 divided by $12 paid = 10%). This is much better than our 6% risk-free return. But life is not that simple. That's $1.20 from last year's earnings. What will happen in the coming year? What will happen after that ?
All this will have to be guessed. And this is where all the professional analysts and big money managers spend their days. So how do you compete with them? This is where a very powerful concept comes into play, introduced by Benjamin Graham. He said think of the stock market as a business partner whose name is Mr.
Market. This Mr. Market is very moody. One day he becomes very happy and offers you shares of his company at a very high price. Much more than its real value and one day he becomes very depressed and is ready to sell the same shares to you at half the price. You don't have to deal every day. You only have to act when Mr.
Market is extremely emotional. When he is very happy then you can sell your shares and when he is very sad and is giving you a good business at a cheap price then you can buy it. This difference between the actual value of the business and the price you buy it at is called the margin of safety. The secret to safe and profitable investing is to always invest with a margin of safety.
But the same question again, what is the real value of a business ? How will this be known? We don't need any rocket science to understand this. There are just two simple things. Wax on, wax off, like a Kara Kid movie. The first thing is earnings yield. Meaning, how much is the company earning in comparison to the price you are paying.
There is a company that is earning $1.20 on every $1 you invest. That means an earnings yield of 10%. There is another company that is earning $2.40 on every $1. That means an earnings yield of 20%. Which is better? Obviously 20%. So rule number one is always look for companies with high earnings yield.
This tells you that you are getting the business at a cheap price. Wax on. The second thing is return on capital. Meaning, how much return is the company earning on the money invested in its business. It took Jason $400,000 to open a gum store, and the store earned $100,000 in a year. This is a return on capital of 50%.
His friend Jimo opened a Just Broccoli store there. He invested $100,000 but earned only $10,000 a year. This translates to a $.5% return on capital. Which business is better? Jason's obviously a good business is one that can earn high returns on your money. Rule number two is to always look for companies with high returns on capital.
This tells you that you are buying a good business. Wax off. That's all. These two concepts together create the magic formula. All the formula does is take a list of thousands of companies and rank them. Ranks first on the basis of return on capital. The company with the highest return on capital is ranked first.
Then ranks on the basis of earnings yield. The one with the highest earnings yield is ranked first. In the end, the formula simply adds these two ranks together. The formula selects the companies which have the best combined rank, meaning the companies which are both good and available at cheap rates.
So the question is, does this strangely simple formula really work? Well, the results this formula has given in the 17-year period from 1988 to 2004 are astonishing. If you had created a portfolio of top 30 stocks according to this formula, your average annual return would have been 30.8%. At this rate, $1,000 would have become over $1 million in 17 years.
The market 's average return over the same 17 years was $.3% per year. A million dollars is a lot. And this formula works not only for small companies but also for big companies. Even for companies with market values exceeding $1 billion, this formula nearly doubled the market returns. Moreover, when the companies were ranked into groups from one to ten on a formula basis, Group One performed the best.
Group two had a little less, group three a little less, and this pattern continued until group 10. It seems as if this formula can predict the future. Then why doesn't everyone use it? If everyone uses it, it will stop working. Isn't it ? Here comes the most interesting thing. The biggest feature of this formula is that it does not always work.
This is its speciality. On an average, this formula performs worse than the market over a period of 5 months. Sometimes it can perform worse than the market for a full 1 year, 2 years or even 3 years. Now imagine you trusted a book and invested your money in a computer generated list of stocks. And now you've been watching for years your friends make more money.
The market is moving ahead and your portfolio is lagging behind. Will you stick to this formula? Most people ca n't keep up. His patience gives way. Even professional money managers cannot survive because their clients withdraw their money and run away, and that is why this formula keeps working. Because to make a clear tick in the long term, one needs deep faith in logic.
Just looking at past results will not work. You have to believe wholeheartedly that buying good businesses at bargain prices is a timeless strategy that will always work. No matter how crazy Mr. Market gets in the short term. A company with a high return on capital, such as 50%, has a special advantage.
She can invest her profits back into the business and grow at a rate of 50%. An ordinary company cannot do this. Such a business easily keeps competition away. And when you get such a good business at a high earnings yield i.e. at a cheap price, then it becomes a powerful combination. You are buying an above average company at a below average price.
What could be more logical than this ? So should you pick individual stocks? The author says absolutely not. If you cannot predict the normal earnings of a business for the next 3 to 4 years, then you have no business investing in individual stocks. The formula works because he buys 20 to 30 stocks at once.
He is placing an average parbet. Individual stocks can be mistaken. But the chances of getting good results on average in a portfolio of 20 to 30 stocks are very high. So what to do now? The plan is very simple. The author has created a website called magicfulinvesting.com which is free. Step One: Go to that website.
Step 2: Select your company size. Companies above 50 million are good for individuals. Step Three: The website will give you a list of top ranked stocks. Step Four: Buy five to seven companies from that list. Initially you have to invest only 20 to 33% of your capital. Step Five: Repeat this process every 2 to 3 months.
Until your entire capital is invested. Within 1 year you will have a portfolio of 20 to 30 stocks. Step Six: Hold each stock comfortably for one year. After a year, sell it and buy a new Magic Formula stock from the list instead. Step Seven: Keep following this process for years. A minimum commitment of 3 to 5 years is required.
No matter what the results are. Remember there is no tooth fairy in the stock market. No one will hold your hand and make you rich. Brokers, mutual fund managers mostly sell the market to
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