The Magic Formula

As mentioned in the previous post, we will take a look at how some other people do their investments so that they get a better-than-market return.

Just before I return the "The Little Book that Beats The Market" (NLB Call No.: 332.63228 GRE-[BIZ]) back to the library, I will have a quick summary of how the little book intends to do just that - give a return that is better than the market.

Most people have the belief that a system that can make money from the Stock Market must necessarily be complicated enough. How else would this explain the need for all those mutual funds and unit trust managers?

The author does exactly the opposite. He shares a method so easy to apply that you wonder if he was bluffing.

In the book, he proposes a method which in essence utilizes 2 financial ratios and by ranking all the companies in such a manner. As a close approximation, these 2 ratios are Return on Assets (ROA) and the commonly used Price Earnings (P/E). He contends that by ranking companies based on these 2 ratios, we will be able to have a list of top performing companies.

The ROA shows how much the company earns with respect to the investment which it pumped in. For example, if a shopfront costs $100 to set up and the profits the shopkeeper gets is $10, the ROA would be 10%. The higher the ROA the better.

P/E shows us how much does a particular stock costs in the Market with respect to the Earnings per Share (EPS) of the company. The lower this number, the better. But not too low. A P/E of less than 5 signifies something abnormal in the past year's results.

By ranking companies according to the ratio, the author is trying to find companies which show a high yield at a relatively low market price.

Of course, profits can change from year to year. But it is assumed that a company with a high ROA has some competitive advantage from its peers that allows it to have a higher return and that this advantage remains for the company.

Pitfalls of this method? It might take 3 to 5 years before the returns starts to show in your portfolio. Another point is that you need to hold 5-8 stocks which ranks high on both ratios. Seems like all investment books from US assumes that the investor has at least US$100,000. This is especially true for books on technical analysis.

But what can a "poor" investor do to maximise returns on his meagre sum of money? Assuming he is a long term investor and won't be needing the money soon, he can:

1. Hide it under the pillow and sleep on it.

2. Leave it in a reputable bank to earn a pathetic interest. This can be 0.25% p.a. if you are not looking hard enough.

3. Pay your life insurance premium to get a "wonderful" annualised return of 5-6% which you'll probably get back when you're 60.

4. Throw the money into a mutual fund and let the fund managers worry for you. If they do good, you get more money and pay them a fee for being such a great help. If they do bad, you curse at them and still pay them the same fee for messing it all up for you.

5. Try buying into an index fund. This is also known as an Exchange Traded Fund (ETF) which allows you to buy indexes as if they are stocks.

Currently, option 5 sounds the most viable. We shall take a look at the past performance and returns of the various indexes around the world and decide which suits our appetite. Till next time!

P.S:
Financial ratios used to describe a company should be intepreted with care. If you think about it, it's not different from using ratios to describe how big an elephant is. Some people use Weight/Height, while others prefer the more interesting trunk length/tail length!