The Little Book That Beats the Market

Buying good businesses at bargain prices is the secret to making lots of money.

Buying good businesses at bargain prices is the secret to making lots of money. The Magic Formula explained. This simple yet powerful strategy involves two key components: Identifying good businesses: Companies with high returns on capital Finding bargain prices: Stocks with high earnings yields The formula systematically selects companies that rank high in both categories, essentially finding above-average companies at below-average prices. This approach has historically outperformed the market by a significant margin. Why it works. The magic formula capitalizes on: Market inefficiencies Short-term thinking of most investors Mr. Market's emotional swings

Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices. Understanding Mr. Market. Benjamin Graham's concept of Mr. Market helps investors understand stock price volatility: Mr. Market is your hypothetical business partner who offers to buy or sell shares daily His mood swings wildly, sometimes overly optimistic, other times pessimistic These mood swings create opportunities for rational investors Long-term rationality. While Mr. Market is emotional in the short term, he eventually gets it right: Over time, stock prices tend to reflect the true value of businesses Patience allows investors to benefit from temporary mispricing This concept underpins the success of value investing strategies like the Magic Formula

The magic formula ranks companies based on two factors: return on capital and earnings yield. Earnings Yield (EBIT/EV): Measures how much a company earns relative to its price EBIT (Earnings Before Interest and Taxes) / Enterprise Value Helps identify undervalued companies Return on Capital (EBIT / (Net Working Capital + Net Fixed Assets)): Measures how efficiently a company uses its capital Identifies companies with sustainable competitive advantages High return on capital often indicates a "good" business Why these metrics matter: They provide a standardized way to compare companies across different industries They account for differences in debt levels and tax rates They focus on the core profitability and efficiency of businesses

Following the formula for any three-year period in a row, the magic formula beat the market averages 95 percent of the time (160 out of 169 three-year periods tested)! Short-term underperformance is normal. The magic formula doesn't work all the time: Underperforms the market in 5 out of 12 months on average Can lag behind for 1-2 years at a time Long-term outperformance is remarkable: Beat the market in 95% of 3-year periods Never lost money over any 3-year period in the study Achieved superior returns with lower risk than the overall market Why patience matters: Allows time for market inefficiencies to correct Smooths out short-term volatility Gives the strategy time to prove…