The Little Book that Beats the Market

by Joel Greenblatt
isbn: 0-471-73306-7
2006
website: http://www.magicformulainvesting.com/

Notes:
Your investment needs to do better than the U.S. government bond that matures after 10 years (which earned 6% when this book was written?)

Buying a share in a business means you are purchasing a portion (% interest) of that business and are then entitled to a portion of that business's future earnings. Figuring out what a business is worth involves estimating/guessing how much the business will earn in the future.

Stock prices move around wildly over short periods of time but doesn't mean that the values of the underlying companies have changes. Buy shares at huge discount to your estimated value of those shares.

purchase a business that earns more relative to the price you are paying. (higher earnings yield)
buy a share of a good business (earn a high return on capital)

Start with a list of largest 3,500 companies available for trading
Rank companies based on their return of capital (highest return is best) 1 best - 3,500 worst
Rank companies using earning yield (highest is best) 1 best - 3,500 worst
Combine rankings and look for the companies that have best combined rankings

If you truly understand the business that you own and have a high degree of confidence in your normalized earnings estimates, owning 5-8 bargain-priced stocks in different industries can be a safe and effective investment strategy

However they recommend holding 20-30 stocks at one time as magic formula works on average. They had 30 stocks held for one year in tax free accounts. If held in taxable accounts sell stocks that are showing a lost from initial purchase price a few days before year is up. For stocks showing a gain, sell a day or two after one year is up so gains receive advantages of lower tax rate affored to long-term capital gains and losses receive short-term tax treatment.

Probably don't want to buy all 30 stocks at once. Add 5-7 stocks every few months until reach 20-30 stocks in portfolio. Than as stocks reach one-year holding mark replace the ones that have been held for one year.

General screening instructions:
Option 1:

1. go to magicformulainvesting.com
2. choose company size. for most people companies with market capitalization above $50-100 million should be of sufficient size
3. obtain list of top-ranked magiv formula companies.
4. Buy 5-7 top ranked companies. To start, invest only 20-33% of money you intend to invest during the first year.
5. repeat step 4 every 2-3 months until you have invested all of the money you have chosen to allocate to your magic formula portfolio. After 9-10 months this should result in a portfolio of 20-30 stocks. (5-6 stocks every 2 months)
6. Sell each stock after holding it one year. Use the proceed from any sale and any additional investment money to replace the sold companies with an equal number of new magic formula selections
7. Continue this process for a minimum of 3-5 years regardless of results.

Option 2: using other screening options

1. Use Return on Assets (ROA) set a 25% minimum as a screening criterion. (This takes the place of return on capital)
2. From the resulting group of high ROA stocks, screen for those stocks with the lowest Price/Earning (P/E) ratios (This takes the place of earnings yield)
3. Eliminate all utilities and financial stocks (mutual funds, banks, insurance companies)
4. Eliminate all foreign companies from list (In most cases these have suffix "ADR" for American Depository Receipt" after name of stock)
5. If stock has a very low P/E ratio (<5 also="also" and="and" announced="announced" any="any" are="are" being="being" company="company" data.="data." data="data" earnings="earnings" eliminate="eliminate" from="from" has="has" help="help" in="in" incidence="incidence" incorrect="incorrect" indicate="indicate" last="last" li="li" list.="list." may="may" minimize="minimize" of="of" or="or" previous="previous" some="some" stocks="stocks" that="that" the="the" these="these" to="to" untimely="untimely" unusual="unusual" used="used" want="want" way="way" week="week" year="year" you="you" your="your">
6. Follow steps 4-8 from above