The Concept Behind Formula Investing

The concept behind Formula Investing is simple. The idea is to systematically follow a strategy that buys above average companies but only when they can be purchased at below average prices. That's it. It is an investment strategy designed to be relentlessly logical, disciplined, and cost effective. Here's how it works:

• Based on the principles I outlined in The Little Book that Beats the Market, stocks are first ranked based on how cheap they are relative to their earnings. In simplest form, a stock that costs $10 and earns $2 per share is considered cheaper and therefore ranked higher than a stock that also costs $10 but earns only $1 per share. (Added adjustments are made to reflect differences in tax rates, debt levels and cash balances between companies.)
• Next, companies are ranked based upon the quality of their underlying business as measured by their "return on capital". In the book, I discussed the case of Jason's Gum Shops. It cost Jason $400,000 to open a new gum shop but each store that he opened was able to earn $200,000 per year. A business that can make $200,000 each year from a one-time investment of $400,000 earns a return on capital of 50% (200,000/400,000=50%). In comparison, the book also considers the case of a business called Just Broccoli. Opening a Just Broccoli store also costs $400,000. But each of those stores earns only $10,000 a year. A $10,000 annual return on a $400,000 investment results in a return on capital of just 2.5%. The business with the 50% return on capital is ranked higher and considered better than the one that earns a mere 2.5%. (Here, too, adjustments are made to reflect differences between company tax, debt, and cash levels as well as adjustments reflecting the actual tangible capital employed in each business.)
• Finally, the two rankings are combined and those 20 to 30 stocks with the best combined ranking, those that appear to have the characteristics of being both in a "good" business and appear to be available at a "bargain" price are selected for the Formula Investing portfolio.

While the Formula Investing strategy has been extensively backtested click here for our most recent study, this does not guarantee that it will continue to work in the future.

The idea is to systematically follow a strategy that buys above average companies but only when they can be purchased at below average prices.

It is true that some companies that rank highly according to the formula may be "cheap" for a good reason. It is also true that some companies that have earned a high return on capital in the past may not be able to do so in the future due to competition, disappointing new products or for many other reasons. However, I believe that choosing 20 to 30 stocks that rank highly according to the formula will result in a portfolio that consists on average of companies that are both good and cheap. As Benjamin Graham famously said, "in the short term the market is a voting machine but in the long term, it is a weighing machine". In other words, market prices may reflect volatile emotions in the short term but over the long term the stock market is actually very good at accurately assessing the value of businesses (though this can often take months or years to happen). If this is true as I believe, many of the bargains in our formula portfolios will be recognized by the market and higher prices will result.

However, I believe that choosing 20 to 30 stocks that rank highly according to the formula will result in a portfolio that consists on average of companies that are both good and cheap.

The catch is this. This is a long term strategy. Even during historic periods that displayed excellent overall backtested results, there were still periods of months or even years where the stocks theoretically selected by the formula did not outperform the market. There were also periods where the market was down and while the theoretical formula portfolio lost less than the overall market average, it was still down. It is virtually certain that these difficult periods will return in the future. In fact, a formula that beat the market every month or every year would quickly be copied and most likely have its excess returns competed away in a relatively short period of time. It is much more difficult to follow a formula that has periods of underperformance even though the strategy makes sense over the long term. But that's one reason why I believe the formula will continue to work. Most investors will continue chasing managers or strategies that have worked well recently.

The benefits of a long term strategy like Formula Investing should go to those who are convinced of the overwhelming logic of owning a portfolio of above average companies purchased at below average prices and who therefore stick with it. This is a strategy meant solely for investors that have a long term horizon, generally 3 to 5 years. Understanding that the strategy makes sense over the long term will be the secret to sticking with it during difficult market periods and hopefully lead Formula Investing clients to long term investment success.