For Stock Market Success Buy Good Stuff Cheap
If you want to be a successful stock market investor, buy pieces of “good” businesses at “bargain” prices.
A “good” business is a business that can earn a high return on capital.
Say you own a gum store that store costs $400,000 to build (including inventory, store displays, etc) and last year that store earned $200,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build, sounds like a pretty good business.
But what if we compared that to another kind of store, say a store that sells only Broccoli. What if it also costs $400,000 to open a Just Broccoli store? But what if that store only earned $10,000 last year? Earning $10,000 a year from a store that costs $400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.
A business that earns a 50% return on capital is better than one that earns a 2.5% return on capital.
A cheap business is one with a high earnings yield.
Take two businesses, one earned $300,000 last year, one earned $100,000. Both are for sale for $1 million. If we buy the first, we get an earnings yield of 30% ($300,000 in earnings divided by the $1 million purchase price). The second has an earnings yield of 10% ($100,000 in earnings divided by the $1 million purchase price). The company that earns more relative to the price we’re paying is cheaper than the one that earns less. Getting a 30% earnings yield is better than a 10% earnings yield — a high earnings yield is better than a low one.
This is the magic formula. If you just stick to buying “good” companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market’s average annual return. And you can do it with very low risk. A study we conducted over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period.
The Magic Formula in Action
Magic Formula {S&P 500}
1988: 27.1% {16.6%}
1989: 44.6 {31.7}
1990: 1.7 {-3.1}
1991: 70.6 {30.5}
1992: 32.4 {7.6}
1993: 17.2 {10.1}
1994: 22.0 {1.3}
1995: 34.0 {37.6}
1996: 17.3 {23.0}
1997: 40.4 {33.4}
1998: 25.5 {28.6}
1999: 53.0 {21.0}
2000: 7.9 {-9.1}
2001: 69.6 {-11.9}
2002: (4.0) {-22.1}
2003: 79.9 {28.7}
2004: 19.3 {10.9}
AVG 30.8% {12.4%}
Over 17 years, earning 30% a year means $11,000 would have turned into over $1 million!
“The Little Essay That Beats The Market,” by Joel Greenblatt