By Charles Euchner
Right now, everyone is scared. Gas prices have passed the $4 gallon mark. The housing bubble, finally, has been pricked. The war in Iraq is going badly, and the wider "war on terror" is doing worse. Silently, with nary a comment, loose nukes once in the Soviet arsenal threaten to make 9/11 look like a fender bender. The public has about as much confidence in the president -- and Congress, too, let us not forget -- reminiscent of the days of James Buchanan.
In other words, the world has no stability.
And so the very idea of investing in the stock market, especially for those of us whose eyes glaze at the sight of the stock pages, seems kind of crazy. True, if you score, you'll do better than putting your savings in a savings account. But, mercy, at least be careful -- put what you invest in conservatively assembled mutuals! Or, better yet, invest in government-backed securities or bonds.
Into this hurricane of uncertainty, I have decided to test a book's promise of a simple, fool-proof system for winning on Wall Street. The Little Book That Beats the Market, by Joel Greenblatt, promises returns better than professional traders, mutuals, gold, real estate -- you name it, his "magic formula" (his term) beats every other approach.
The promotional material promises: "Though the formula has been extensively tested and is a clear breakthrough in the academic and professional world, the common sense method is convincingly explained using 6th grade math skills, plain language and humor."
Hey, I graduated sixth grade. Why not give it a try?
And so, tonight, I am going to invest a few thousand dollars Greenblatt's way. And I will report back on a regular basis about the success of my high-rolling. As I proceed, I plan to add more to the pot. I won't get rich, because I don't have much to start with. But if Greenblat is right, I'll do better than most people who diligently buy IRA's and mutuals and bonds -- and, more recently, gold and land.
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The book's argument
Gteenblatt's agument goes like this:
The stock market is one crazy system -- if looked at from the perspective of a few months or even a year. Prices fluctuate wildly. Is it because the core value of companies jumps up and down? No. It's because people buying and selling stocks tend to be reactive. When prices fall, people panic. When prices rise, people want to jump on a bandwagon. Ergo, the market fluctuates, even if the company's fundamentals are fundamentally sound over time.
If only there were a way to identify and buy valuable stocks at their low ebbs . . .
Greenblatt says there is. Following the logic of Benjamin Graham -- the economist whom Warren Buffett proclaims his greatest influence besides his father -- Greenblatt says to watch two numbers:
Return on Capital -- The level of profitibility relative to fixed and liquid assets. ROC shows you how much the company is making off its investments. The formula, for you digit-crunchers out there, is: ROC=EBIT/(Net Working Capital + Net Fixed Assets. That is to say, it's the ratio of pre-tax operating earnings (EBIT) to the tangible capital employed by the company.
Earnings Yield (EY) -- Earnings per share divided by the share price, the EY shows you just how much profit you get over and above the stock's price. If you earn $1.20 on a stock worth $1, , you have a 20 percent rate of return. That's about four times better than what you get by putting your cash in a bank.
Greenblatt then ranks companies listed with a stock exchange for these two measures. Then he adds together the ranking of the companies for each measure. Voila, he has a compound measure that's as easy to calculate as OPS (baseball's influential stat based on on-base percentage plus slugging percentage).
If a company ranks high among both measures, it's got deep value. If you can get it at an ebb in price, you have a bargain. If you can hang on to the stock for more than a year -- better, more than a few years -- its value will be borne out.
Making my first investment
Here's what's even better. Greenblatt has set up a web site that does all the calculations for you. It's called magicformulainvesting.com. Go there and make a few simple choices, and you'll get stock picks with longterm value. I sought out the top 100 companies with a minimum market capitalization of $500 million. (The complete list of these stocks can be found at the end of this post.)
To start, I decided to invest about $3000 in five stocks. Here's what I picked (May 31, 2008):
McGraw Hill Publishing (MHP): $41.17 -- 25 shares ($1029.25)
Nutri/System Inc. (NTRI): $20.52 -- 20 shares ($409)
Meredith Corporation (MDP): $32.81 -- 20 shares ($656.20)
Korn/Ferry International (KFY): $16.80 -- 25 shares ($420)
Sigma Designs Inc. (SIGM): $18.50 -- 20 shares ($370)
Followup
Greenblatt recommends buying a few stocks at a time until you have a portfolio of 20 to 30 stocks. Why? Because the stats are based on last year's performance, which can always be an oddball year. Having a mix of stocks assures that you're getting a good mix of stocks.
It's been almost two and a half months since I bought these stocks. How are they doing? As of today, August 13, 2008, the prices are:
McGraw Hill Publishing (MHP): $43.27 -- 25 shares ($1081.75) Nutri/System Inc. (NTRI): $19.91 -- 20 shares ($398.20) Meredith Corporation (MDP): $29.25 -- 20 shares ($580.50) Korn/Ferry International (KFY): $19.11 -- 25 shares ($477.75) Sigma Designs Inc. (SIGM): $18.31 -- 20 shares ($366.20)
So I have two winners and three losers so far. My total value has gone from 2884.45 to 2904.40. This at a time when the Dow fell from 11,642 to 11,532. My gain was not great, and the market's loss was not great. So far, call it a wash. But stay tuned . . .
In a few weeks, I'm going to have to make decisions about what to buy next. Any ideas, out there?
