Are you a low price to book or Magic Formula value investor? If you are you will definitely find this article, sent to me by one of our subscribers – Piero Marotta from Italy – of interest.
Piero has come up with an interesting investment strategy which combines a low price to book ratio with the idea of the Magic Formula.
Over to Piero…
I am a big fan of Joel Greenblatt.
I have read all his books and have them in paper and a kindle version!
I went so far to download and print notes of his lessons in 2005 from a student at the Columbia University and also watched the videos of his lessons.
His style is engaging and his research and writing makes a very compelling argument to try his style of value investing in the real world.
However what I immediately realized after having listened to him is that if I have to be as smart as Joel to be successful in investing I’d better stop before I even started.
You do not have to be as smart
Luckily we don’t need to be that smart to do well in the market as long as we are consistent in implementing the strategies of value investing.
And we are strong enough to endure the inevitable periods of under-performance and drawdowns.
The principle of a cheap stocks and a good business
The most popular Greenblatt’s strategy is the Magic Formula. I will not talk about as it has been the subject of countless articles and forums.
What I would like to focus on is the basic concept of the Magic Formula that investing in:
- Good businesses
- At bargain stock price
Will give us good returns on average.
In essence the strategy is: Get the best you can for what you are prepared to give.
What you give is the price you pay for the stock and what you get is an undervalued business.
How you define undervalued is a matter of choice, some investors focus on cash flow, others on earnings or dividends.
The Magic Formula with price to book
I prefer using the price to book ratio to find undervalued companies and will show you how you can combine a low price to book investment strategy with the Magic Formula.
Cheap stocks investment strategy
A classic value investing strategy is to buy a basket of stocks with a low price to book ratio.
Many books and research studies have demonstrated that a low price to book strategy returns, over the long term, a compound annual growth rate of around 10%.
In the chart below you can see the back tested returns for a low Price to Book investment strategy applied to European stocks.
Cheap and Good investment strategy
When combined with a metric that allows you to identify good businesses, such as the Return on Equity (ROE) there is a considerable improvement of the returns, up to a 20% compound annual growth rate (CAGR).
This is a way you can get rid of bad companies that have a low price to book ration only because they have a low ROE.
Below is a chart that shows you the return of the high ROE low price to book investment strategy compared to only a low price to book strategy.
How to implement a high ROE low PB strategy
To implement this strategy you need to put together the following simple stock screen:
- As a first filter search for cheap companies by looking for low PB companies (use the book to market ratio to do this, here is why: Why use book to market and not price to book? )
- Use a second filter to search for good businesses with a high ROE
- This will give you a list of good companies at bargain price.
For exact (step by step) instructions on how to implement this screen click the following link:
How to implement the price to book magic formula
Wishing you profitable investing
PS: For step by step instructions on how to get price to book magic formula investment ideas click here: Get price to book magic formula investment ideas
PPS: Why not sign up now, while this is fresh in your mind?