Sunday, June 01, 2008

“The little book that beats the market” - By Joel Greenblatt

Grahmian principles used in the Magic formula
· Mr Market is subject to mood swings
· Margin of safety – buy shares only when they trade at significant discount to their true value

Magic Formula
buy shares in good businesses (one with high ROE’s) but only when they are available at bargain prices (priced to give us a high earning yield)

Choose simplicity
Willing suspension of disbelief – we choose to ignore simplicity. An analogy to the movie “karate kid” is shown; how Mr. Miyagi teaches karate to his apprentice Daniel by making him wax cars, paint fences. Daniel who is initially reluctant on the merits of such methods later realises how such primitive methods create a solid foundation for him to learn karate.

Magic formula computation
· Rank companies first with ROC and then Earnings Yield with higher rank being given to high ROC and Yield resp.
· Aggregate the above two ranks
· Magi c formula stocks are the ones which rank higher on a combined basis

ROC – Return on capital = EBIT/(Net working capital + Net fixed assets)

  • Depreciation is assumed to be equal to maintenance capital spending requirements, so EBITDA – Maintenance Capex = EBIT
  • Net working capital – how much capital is needed to run business
  • Excess cash not needed to run business is excluded
  • Short term interest bearing debt was also excluded
  • Net fixed assets excludes goodwill

Earnings Yield - EBIT/EV

  • EBIT/EV is used instead of E/P (Earnings Price) ratio as it doesn’t get distorted by leverage

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