The Little Book That Beats the Market

Core lessons

The 8 Fundamental Lessons

1. Lesson 01

   The market constantly prices things incorrectly and that is the opportunity.

   Practical application

   The next time a company you know well has a bad quarter and its stock drops significantly, do not assume the market is right. Ask yourself: has the business permanently deteriorated, or is the market making a short-term emotional mistake? That question is the beginning of the analytical process.

2. Lesson 02

   Two numbers are all you need to identify a great investment.

   Practical application

   Before applying any other analysis to a company check these two numbers. If the ROIC is below 15% the business is mediocre regardless of what the story sounds like. If the earnings yield is below 8% you are probably paying too much. Both need to pass before anything else matters.

3. Lesson 03

   Good business plus good price is the entire strategy.

   Practical application

   Think of every investment as requiring two separate approvals. First approval: is this a genuinely good business? ROIC above 25% is the standard. Second approval: is the price reasonable? Earnings yield above 10% is the standard. If either fails the investment fails regardless of the story around it.

4. Lesson 04

   The formula works because it is uncomfortable to follow.

   Practical application

   Decide in advance that you will follow the formula mechanically for at least 3 years without modification. Write that commitment down before you start. The real test: can you hold the list through a period when it underperforms for 12 consecutive months without changing anything?

5. Lesson 05

   Rank both metrics independently and combine the rankings.

   Practical application

   When you implement the formula never compromise one metric for the other. A company with extraordinary ROIC that is expensive is not a Magic Formula candidate. A company with excellent earnings yield that has terrible ROIC is not a Magic Formula candidate. Both numbers need to be in the top range of the universe simultaneously.

6. Lesson 06

   Exclude banks, utilities and financial companies from the universe.

   Practical application

   When you screen for Magic Formula stocks filter out financials and utilities before running the ranking. The universe you are ranking should be operating companies only. Most stock screeners allow this as a standard sector filter.

7. Lesson 07

   Hold each position for approximately one year before rotating.

   Practical application

   Track the exact purchase date of every position. Set a calendar reminder at 11 months to evaluate whether the position has a gain or a loss. If it has a gain wait until just after the one-year anniversary to sell. If it has a loss consider selling just before to capture the short-term tax benefit.

8. Lesson 08

   The formula has the strongest results in small and mid-cap stocks.

   Practical application

   When you implement the formula focus the universe on companies with market capitalizations between $50 million and $2 billion. This is where the formula has historically produced its strongest results. The large-cap version works but with more modest alpha because those companies are more efficiently priced.

Related concepts