Saturday, February 26, 2011

"Magic" Formula?

I just went to a investment seminar by iFast Capital this afternoon and was little disappointed to find out that there wasn't much information shared considering the fact that I went to a quite educative seminar by iCapital last August. Well it wasn't really that bad a seminar actually. What I think is it is targeted to those who like to know a little but wouldn't like the trouble to analyse a little deeper on the economy and investment - although I do felt the speakers put too much focus on their fund (I have a friend who told me that "that is what financial advisor is about"). But it is a good time for potential unit trust buyers to meet the fund manager because I think if you were to invest in equities fund, you have to meet the manager to make sure both yours and his/her goals are aligned.

Well there are few reasons why I don't like equities unit trust but I'm not going to discuss to much about it today. If that is the case, is there a way to get exposure to equities if one don't like the intensity to analyzing and picking individual stock? Yes of course, you can buy ETF where you'll be investing in a little bit of everything - that your wealth will grow along with the market at a pretty low cost. But what if you are someone in between and you want to beat the market?



If you are the kind who pick your own stocks, well turn away because I don't want to waste your time. But if you aren't read on.

I came across this book called The Little Book That Beats the Market while I was searching for The Little Book  of Economics. I am not here to promote the book nor review it, but there is an interesting formula mentioned by the book called the "magic formula". Yes, magic. And I'll show you part of it not all of it because I don't want to take away the credits from this book.

What this formula does is that it ranks the stocks which have the highest ROE and the lowest PE combined. And you'll buy the top few ... erm .. not few actually but some of the top in the rank (the magic number is in the book anyway).

Ideally........
Why high ROE? ROE is return on equity and generally the higher the ROE the more profitable the business is.  It basically means the earnings return a business gets on its capital or equity invested. I don't want to get into too detail in it but it is something like your interest rate the higher it is the more you get. And usually business with high ROE have a high growth potential because of the higher returns it could generate from its invested capital.

ROE = Total Earnings / Total Equities

I'll put 15% as the "magic" number of high ROE.

Why low PE? PE is price to earning ratio which mean the lower it is, the cheaper the stock is in valuation term. It also means you'll get more of a something from the price you pay for a stock. Some says, it is how valuable a stock is. The lower the PE is the less valuable the stock is. wait...wait...wait...How can something not valuable be a good investment. Well, this is why investors should love the stock market because there will be time where the market will see a profitable business as a junk. 

PE = Market Price / Earnings

I don't have a "magic" number for this but something below 10 should be considered cheap.

If you combined both of those criteria together, you'll get to buy a profitable company at a low price. Isn't that sounds like value investing? Yes, close.

So get a piece of paper or an Excel sheet, rank them and buy a few....erm...not few but some of the top in your list. Okay, why do I say some (actually not some also la, you'll probably need about 30 stocks). That is because you have to diversify if you were to use this strategy. Information on ROE and PE are readily available if you know where to find. If you look at the word "Earnings" that I highlighted just now, that number you get is actually accounting earnings. It may or may not represent the true economic of a business and normally it doesn't. In layman terms, it reported its earnings according to the accounting principle it adopted. Why do they report such a misleading number? One, that is the law lor...two, there is no perfect or even proper way to report an accounting figure. But as Buffett puts it, he and Charlie will be lost without those numbers. So normalization and adjustment have to be made on the reported earnings. 



Not just that, high ROE doesn't always mean high profitability or growth because a business can take debt to lower denominator and if the business returns all its earnings as dividend it may not grow as fast. But both action can result a high ROE. Same goes to PE, lower doesn't always mean cheaper. It can be really a junk because both ROE and PE is actually old figures and the reason it becomes low is because its future economics no longer favors them. Think newspaper.

But if you were to use this formula you definitely wouldn't want to do all that time consuming effort. In this case, you'll definitely have to diversify to spread the risk across. In that many stocks you'll probably get a few losers but the winners are not just able to offset the losers but will give you a decent return. That's what the book claims and I think it does make sense that's why I share this.

If you need prove you'll have to read the book. It shows its track record on US stocks and most of the time it beats the market. How bout Malaysian stocks? I don't have the figure to show because that is not how I invest. I am merely sharing how it can be done in an easier way. Oh come on, you have to do some homework right. 

Will it work on Malaysian stock then? I think it does make sense and it might work. Hey, I started value investing thinking it might work.

Disclaimer: This is not my idea and I don't want to take credit for this. I am merely sharing and commenting on it.