Investment guru “step by step” teaches you to choose stocks
Can a “magic formula” make it easy to select good stocks?
Joey Greenbrae's investment experience and philosophy
Have you heard of the magic formula? It is said to be a “profit formula to beat the market,” a value stock selection formula with only 2 indicators. It is said that over the past 17 years, the annualized return of the 30 stocks selected by this formula has reached an annualized return of 30.8%, while the average annualized return of the stock market during the same period was 12.3%.
Before we talk about this formula, let's take a look at its originator — Joel Greenblatt (Joel Greenblatt).
Greenbrae was born into a family of Jewish merchants, so he seems to have been very business-savvy since childhood.
While attending the Wharton School at the University of Pennsylvania, he and two good friends wrote a paper that updated Benjamin Graham's stock selection method and published it in the “Journal of Portfolio Management.” After that, although he studied law for a year at Stanford Law School, he dropped out of school to pursue a career in finance. You can see how strong his interest in this field is.
In 1985, Greenbrae and his business partner Rob Goldstein (Rob Goldstein) founded hedge fund Gotham Capital (Gotham Capital). They have achieved very impressive results there. In the ten years from 1985 to 1994, their annualized return reached 50% (before deducting expenses), and their annualized return after deducting expenses was 30%.
However, the investment portfolio always falls sharply every two or three years, which puts a certain amount of pressure on him. In addition, he began to pay attention to personal issues such as family happiness and enjoyment of life, so they returned the money to all external investors at the end of 1994. It's also very real!
After that, in addition to continuing to design, implement, and test their investment strategies with Goldstein, Greenbrae began teaching courses such as “safety analysis” and “investing in value and special circumstances” at Columbia University.
However, later, Greenbrae changed his mind, founded Gotham Asset Management (LLC) in 2008, and began re-accepting external capital in 2010 to raise four levels of mutual funds totaling 360 million US dollars. Since then, these funds have grown rapidly.
Greenbrae also did one thing that people relish, which is to create a value investment club website. This website has a membership system, and the review is very strict. Members post many investment suggestions on it, and Greenbrae has also discovered some promising fund managers.
He has also written many books, including “You Can Be A Stock Market Genius” (You Can Be A Stock Market Genius), “The Little Book That Beats the Market” (The Little Book That Beats the Market), “The Big Secret for the Small Investor” (The Big Secret for the Small Investor), etc., through these books, he conveyed his investment ideas and strategies to ordinary investors.
So what are his investment ideas and strategies? Influenced by Graham and Buffett, Greenbrae insisted on value investing and buying good, cheap companies. It is reflected in strategy, that is, the “magic formula” mentioned above. Stock selection is carried out through an index that measures valuation and an index that measures the quality of a company. There is a detailed introduction in the book “A Little Book on Overcoming the Market.”
Joy Grimbrae's Magical Formula
So what exactly is that amazing formula in his mouth?
Simply put, it includes 2 indicators and 1 ranking. Let's take a look at the details below.
1. First, use return on capital (return on capital) to judge a company's ability to manage assets, and use return on earnings index (return on earnings) to analyze stock valuations.
How do you calculate the return on capital here? The return on capital ratio used by Greenbrae = Earnings Before Tax (EBIT)/(Net Operating Assets+Net Fixed Assets).
The denominator represents tangible assets. The entire formula reflects the profitability of the invested tangible capital, so of course the higher the better. The surplus portion is based on the figures for the last 12 months, and the asset portion is mainly based on the most recent balance sheet. Surplus before tax and interest before tax, not after tax, is used here, mainly to avoid the impact of different corporate tax rates and different levels of debt.
Also, Greenbrae believes that in order to expand the effectiveness of the magic formula, if return on assets (ROA) is used as a screening criteria, then the minimum value should be set at 25%.
So how do you calculate the return on profit here? The return on earnings ratio used by Greenbrae = Earnings Before Tax (EBIT)/(total market value of shareholders' equity+net interest-bearing debt).
The denominator represents corporate value. The entire formula can be understood as: what is the profit margin that buying this company at the company's value is likely to bring in each year. Theoretically, the higher the better this indicator. It is basically the opposite of the numerator denominator of the price-earnings ratio, so a higher return on earnings may also reflect a lower valuation.
Greenbrae believes that price-earnings ratio (P/E) can also be used for screening, but in this case, the higher the price-earnings ratio, the lower the ranking.
2. Then, for all companies (the examples in the book are 3,500 large companies in the US stock market, with a total market value of over 50 million US dollars): they are ranked according to the return on profit ratio (from 1 to 3,500), and also according to the return on capital ratio (from 1 to 3,500); the higher the index, the higher the ranking.
3. Finally, add up each company's two rankings. The lower the total value of this ranking, the more worth choosing. For example, Company A has a return on earnings ranking of 20, a return on capital ranking of 500, and a total value of 520; Company B has a return on earnings ranking of 100, a return on capital ranking of 300, and a total value of 400. Well, according to this formula, Company B is more worth choosing than Company A.
4. After ranking, you can buy 5-7 of the best ranked companies. At first, you will only invest 20%-33% of the amount you are prepared to invest in the first year. Then buy another 5-7 companies every two or three months, and have an investment portfolio of 20-30 companies after 9-10 months.
5. He also recommended excluding all utilities and finance stocks (because he believes that the timeliness and completeness of such company information needs to be considered), all foreign companies (stock names with ADR), companies with a price-earnings ratio of less than 5 (the previous year or the information used may be unusual), and companies that only announced profits last week.
6. After a year, sell the old company you already own and re-select a new company according to a magical formula. This strategy must be adhered to for at least 3-5 years.
Greenbrae believes that through this strategy, it is possible to find cheap and high-quality companies, thereby achieving good investment results.
How do we apply this formula?
Having said that, how can we apply this formula to specific stock selections?
First, there are two points that need to be clarified. First, although according to Greenbrae, better returns have been obtained by applying this “magic formula,” the past does not mean the future. The market is constantly changing, so we need to be in awe of the changes and make our own flexible adjustments. Second, its “usefulness” is based on a longer time dimension. It also often doesn't work for several years, so you also need to be patient when using this formula flexibly.
Based on these two points, the “magic formula” inspired us to select stocks: return on capital (or return on assets) and return on earnings (or price-earnings ratio) can be considered as indicators for stock selection. Well, in the initial screening stage, we can obtain two more general quantitative indicators:
1. Return on assets ≥ 25%
2. The price-earnings ratio is less than X. The value of X is based on wisdom, and is also related to industry and business. However, apart from companies that are growing very fast, it is generally believed that a price-earnings ratio below 20 is relatively reasonable, so let's first assume X is 20.
On the basis of this basic screening, it is easier to analyze and rank, etc.
What else can be done in specific practical terms?
Next, let's take US stocks as an example and use the Futubull Stock Selector to practice.
We selected 82 stocks through these two indicators (according to data from October 18, 2023).
*Note: The images shown on the screen are for illustrative purposes only and do not constitute any investment advice or guarantee.
So what are your next thoughts on these stocks?
If you are interested, you can try using the logic of the “magic formula” to rank these stocks separately according to two indicators, add up the rankings, and then conduct a more specific analysis of the top individual stocks.
Of course, this is not the only one. There are many other ideas, such as looking at which industries and sectors you are more or less optimistic about, or which individual stocks you want to eliminate.
After further analysis and narrowing, I believe you will feel more about some of these individual stocks.
Of course, when I'm going to introduce you to the “magic formula” today, I don't want to give you direct stock selection advice, but I hope it will inspire you. If you have any thoughts on today's content, please leave a message to let us know.