Sunday, August 30, 2015

The Magic Formula

Greenblatt presents a “Magic Formula” for buying good companies at good prices. A good company and good price is identified based on two financial ratios.

 (ROIC)  Return on Invested Capital represents “good company” while Earnings Yield represents “good price" 
ROIC tells us how much cash a business is able to generate in relation to the capital invested in them. As an investor, it means how much money you are able to take away from the business in relation to what you have invested.
 Earnings Yield tells us an an investor how expensive the company with respect to the earnings it generates.  Is a rupee worth more than or lesser than itself at the given instance. This is a key ratio to determine an investment.

The Magic Formula considers these ratios in equal weight and ranks all companies as Good Company (ROIC) and Good Price (Earnings Yield).  Their ratings on both counts are added together.  As per the formula, the investor buys and holds the companies with the best combined rankings for a period of only one year. He then sells them and does the same allover again. This method is clean and simple, yet effective for someone who wants wants to learn about investing. You can start by reading the little book on investing.  

In India, we need to consider an important parameter, which is quality of the management. We have to consider management that are highly focused and believes in allocation of capital. Companies that dilute equity very often will not reward investors.  As a noted investor quoted about JSPL, a company operating in a sector where there external problems. the company although is in the commodities (steel & power) had returned a CAGR of 37% over the last 15 years (share price from Rs 1 (2001) to Rs 156 (2014). It goes to prove that if the management is good, it can grow and survive in any market.