Monday, May 28, 2007

Reflections on the little book that beats the market (blue)

This is the second little book series which I've read. I previously read the green one on value investing. This blue one is also about investing, as opposed to trading. Quite interesting.

The author uses very simple language that explains perfectly what does 'analysing' a company's value means. I'm not going to talk about that. Instead, I'm here to share what the book describes as a magic formula to beating the market (which I view sceptically). The results of data testing over 17 yrs (US market) is indeed very very impressive. Here's the magic formula in my own words:

1. The key concepts of the formula is number 1: return on capital and number 2: earnings yield.

2. The idea here is to rank all the stocks in the market (regardless of large or small caps - it works equally well, better for small caps) using those two central concepts. Rank no.1 is for those with the highest return on capital and a separate ranking is used for earnings yield with the highest earnings yield as rank no.1 too. Add the two ranking together and buy those stocks with the lowest combined ranking (i.e. those with the highest return on capital and highest earnings yield combined)

3. There is a free dedicated website for it :
It's for the US market though.

4. The key thing here is to diversify into 25 - 30 stocks because some of the stocks chosen by the ranking system will suck big time. But the key is that the average returns will be tremendously high, over a long term. It never lost money in a 2-3 year time frame. Each stock is held for a period of 1 yr and repeated application of the formula is need.

The specific formula for return on capital is

EBIT/(net working capital + net fixed assets)

EBIT (pre-tax earnings is used) instead of earnings after tax because this can be used to compare different companies with different debt and tax rates with the distortions.

Net working capital + net fixed ssets (tangible capital) is used instead of total assets. Goodwill and other intangible assets are removed.

Earnings yield formula used is

EBIT/Enterprise value

Enterprise value is the market value of equity (including preferred shares) plus net interest bearing debt

An example provided in the book will make it so much clearer

P/E ratio for company A = 60/6 = 10 (price per share divided by net income per share)
P/E ratio for company B = 10/3 = 3.33

E/P for A = 6/60 = 10%
E/P for B = 3/10 = 30%

You earn 10% for every dollar purchased for company A while you earn 30% for every dollar purchased for company B. P/E for company A is so much higher than P/E for company B, which means you pay more price for the same earnings for A than B.

That makes company B a better buy right? Well not really.

It's better to look at earnings yield or EBIT/EV

EV for A (market price + debt) = 60 + 0 = $60
EV for B = 10 + 50 = $60
EBIT for both A and B = 10

That makes the earnings for both company the same! Whether one pays $10 per share and owe $50 per share (company A) or one pays $60 and owes nothing is the same. That's why EBIT/EV is used to calculated earnings yield rather than just E/P.

But the book doesn't conclude which is a better buy. I have to analyse this myself. In bad times, because company A does not borrow any money to finance its business (no gearing), it is actually better. Company B need to pay interest and might affect its cash flow, especially during recession, so the survivability might be questionable. I think I need more information.

I need to see what's the long term debt to assets ratio is like for company B. Might be reasonable. Argghhh..I don't difficult.

Skeptical as I am (esp about owning 20-30 stocks), I think I learnt some good lessons here on the use of the 2 ratios used in the magic formula. It makes sense.


Mr Chua said...

my takeaway on this easy to read book is - suspension of disbelief.

Like many "gurus" out there who claims can help people to make 10k/month trading using their proprietary method, etc............

I mean if it is that simple and applicable in real life, wouldn't everyone be doing that?

In reality, most will not even attempt to put their money to test out this simple idea (what's more - he even provide the free screener)

Wonder if there is such free stock screener we can use for sgx markets?