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The magic money machine.Navigation: Main page Author: McGugan, Ian1 Section: On Investing
There's no shortage of simple formulas for picking stocks. But this could be the simplest one yet When I was seven, my father took me aside and explained that, strictly speaking, my plans to print my own dollar bills in the basement might not be entirely legal. Dad saved me from becoming Canada's youngest counterfeiter, but he didn't put an end to my obsession with money machines. I've been fascinated ever since by the idea of building a simple device that would spew out profits, year after year. Other people must share the same fascination, because there's no shortage of stock-picking systems that claim to beat the market. The most famous is the Dogs of the Dow strategy, which requires that once a year you buy the 10 stocks in the Dow Jones industrial average that have the highest dividend yields. Don't like the Dogs? Then you can try other formulas, ranging from Benjamin Graham's Simplest Way to the Motley Fool's now disavowed Foolish Four approach. Most of these strategies boast that they've beaten the market for years. Put them on the spot, however, and nearly all the supposed market beaters begin to stammer and make excuses. It's true, for instance, that if you go all the way back to 1928, you find that the Dogs have beaten the Dow by a couple of percentage points a year--but if you crunch the numbers year by year, you find that taxes would have eaten up most of the added gains. Furthermore, the Dogs are prone to long bad stretches (take the past decade) when they lag behind the market. Still, hope springs eternal. In November, Joel Greenblatt, a hedge fund manager in Manhattan and now an adjunct professor at Columbia Business School, zoomed onstage with the fanciest money machine yet. Greenblatt, who is no fan of delicate understatement, calls his the Magic Formula and espouses it in his newly published treatise, modestly entitled The Little Book that Beats the Market. The Magic Formula consists of picking U.S. stocks that are both highly profitable (as measured by their return on capital) and also relatively cheap (as measured by their earnings yield). To make matters so simple that even my seven-year-old self could have employed his system, Greenblatt has launched www.magicformulainvesting.com. You go to the website, punch in your minimum requirements for market capitalization, and, presto, a list appears of the top-rated stocks that meet your parameters. It's free (at least for now), and all you have to do is to buy a handful of Magic Formula-approved stocks every few months until you have a diversified portfolio of 20 to 30 companies. Can smart investing really be this simple? Greenblatt swears it's so. He's back-tested the Magic Formula over 17 years beginning in 1988, and it's beaten the market in 95% of the rolling three-year periods during his study. What do I think? It's easy to point out flaws. For one thing, Greenblatt acknowledges his approach doesn't work with financial service companies or utilities. For another, the Magic Formula doesn't rule out companies with loads of debt, so many of the companies that pop up on the screen tend to be highly leveraged enterprises that could take a hit if interest rates rise. There's also the question of why these stocks are cheap. The firms that populate the top level of the Magic Formula screen often have question marks tattooed all over them. For instance, Career Education Corp. (Nasdaq: CECO), a provider of adult education, has received notice that regulators may strip its American InterContinental University of accreditation. UST Inc. (NSYE: UST), a maker of chewing tobacco, may one day become a target of litigators who want it to examine its product's role in causing cancer. Oddly, though, I've become addicted to the Magic Formula site. It turns up companies that I never would have thought of looking at and has alerted me to interesting situations, such as King Pharmaceuticals (NYSE: KG) and Claire's Stores (NYSE: CLE). I have to admit, too, that I like Greenblatt's book. Underneath its hokey title is a fun primer on value investing. To his credit, Greenblatt stresses that his formula is at best Muggles' magic--it can trail the market for several years at a time. He recommends you begin Magic Formula investing only if you're prepared to stick with it for at least three years. So is this the money machine I've wanted for decades? I think it's a decent start, but to make it go you have to do your own research and you have to control your inevitable panic when things hit a bad stretch. In other words, you're only going to make money if you're prepared to work at it-which, come to think of it, was precisely the point my dad was trying to make years ago. PHOTO (COLOR) PHOTO (COLOR) ~~~~~~~~ By Ian McGugan, is former executive editor of Canadian Business and editor of MoneySense. FEEDBACK letters@canadianbusiness.com. in the Fair Use guidelines of the 1976 U.S. Copyright Act. info [at] singlearticles.com Powered by CommonSense |
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