Magic Formula Investing / Little Book that Beats the Market

Here is how it started. My financial situation was good, but really in chaos.

Accounts all over the place - 4 different 401 Ks / ROth IRA from former employers and things setup in the past and ignored for a while. 6 different bank accounts (personal and small business accounts), all that required balances (which I kept in order to avoid $10 charges - while not gettting any interest on really losing money - another topic for the future). My wife had US savings bonds from her grandpa in a drawer colecting dust and earning a 4% return.

So I wanted streamline -- I walked into the local Fidelity and moved all my retirement plans and brokerage accounts to Fidelty (about $100 K) -- once this is all there (it takes weeks before these other places send the money (another future topic) I am planning to pick some good mutual funds, continue to save, and watch the money grow. But all the bank accounts resulted in $55,000 in just cash (plus we had a good end of 2005 in our business) - which I wanted to invest in stocks myself. I bought 4 different magazines, 2 of which happened to have a write-up on the Little Book that Beats the Market.

I just decided to try it out for real -- why not -- I did not have a better system -- this seemed like a simple and workable plan and I just went for it - this was around Feb 22, 2006.

The Formula (this is from another article)
What is the magic formula? Invest in good companies when they are cheap. As Mr. Greenblatt might say: See? We told you it sounded obvious. Yeah, so what's "good"? And what's "cheap"?
Good companies earn high returns on their investments, he explains, while cheap companies sport share prices that are low (based on past earnings). His proxies for these criteria are return on capital (operating profit as a percentage of net working capital and net fixed assets) and earnings yield (pretax operating earnings compared with enterprise value, which is the market value plus the net debt). To make things simpler still, his free Web site, www.magicformulainvesting.com, screens companies using his criteria. He advises individual investors to buy a basket of top stocks and turn them over on a strict schedule, depending on how they perform. (For maximum tax advantage, sell losers just before a year's up, and winners just after a year.)
It sounds too easy. But in fact, his approach is difficult not because it is hard to understand, but because it requires patience and faith that you are right when the market is saying you're wrong.
This is based on Warren Buffett's investment principles. But they bear repeating. Even a die-hard value investor like Mr. Greenblatt says he didn't realize that trying to find cheap, good companies, rather than just cheap ones, was so important until the 1990s. While Mr. Graham, Mr. Buffett's mentor, was looking for starkly cheap companies, Mr. Buffett wants only the great ones.Greenblatt's backtesting shows that buying stocks that rank highest in a combination of earnings yield (the inverse of the price-to-earnings [P/E] ratio) and return on capital have doubled the market's returns, and his website shows what stocks pass the test right now.

The Work before:
I read everything there was out there about the book - but did not actually buy the book (that seems a little stupid - I know) . But it did not really seem worth it - the website http://www.magicformulainvesting.com/ really explains all you need to know.

Concerns I learned about:
- past performance does not translate into future success.... I understand that / hear that, but I really don't buy it. When you buy stocks you buy the business prospects for the respective products and the talents of the people who work there. I used to be an athlete - you don't rise to the very top by accident.
- transaction costs, that actually worked out ok for me -- with my account the first 100 trades are only $2.95, so if I but 30 stocks it is still less than $100 or less than .2% of the total (or.4% for a buy and sell).
- people just trashing the idea -- screw them
- the long-term commitment required -- I guess time will tell... that is really all I can say.
- Cherry picking the stocks -- looking at a list of 50 stocks and then using my own "filters" to pick and choose - something the author of the picks recommends against.

NEXT POST -- Put it in action