Winning Formula to Buy Stocks
Five step formula to buy winning stocks.
Joel Greenblatt a hedge fund manager who earn 24% return per year from 1988 to 2009 wrote about his five step formula to find the best equity investments in his book "The Little Book That Beats the Market"
Consistent revenue growth.
Stock prices ultimately rise due to the expectation of future business growth. "I like seeing a company that has multiple years of consecutive revenue growth." - Joel Greenblatt
Company is more productive with less capital.The best businesses are able to use assets more efficiently to produce high rates of return. This can be calculated from their financial statements as return on assets (ROA). The formula for ROA is net income divided by total assets. "I like seeing a company that has a ROA of at least 10%." - Joel Greenblatt
Dividend increases.Dividends are an important signal to investors since companies need actual cash to make payments. A rising dividend shows that management is confident in the businesses ability to navigate the current economic environment. "I like seeing a company with at least 10 or more consecutive years of dividend growth." - Joel Greenblatt
Company should have low debt relative to the business.Companies with too much debt (highly leveraged) have less flexibility to react to economic changes. Right now we are seeing many over leveraged companies being forced to declare bankruptcy since they can not afford to make the interest payments on their debt. In most case when a company declares bankruptcy the Common Shareholder (buyer of stock) is wiped out. "I like seeing a company that has a net debt-to-EBITDA of less than 4." - Joel Greenblatt
Future returns depends on the price you pay today.Over paying for the best businesses can be as big a mistake as buying declining businesses at a cheap price. Both can lead to negative or low future returns. The best businesses usually trade for a premium verse the overall market but you should not pay any price for the privilege of being a common stock holder. "I like seeing a company that has a price-to-earnings multiple of less than 25." - Joel Greenblatt
The book is a great read to really understand how one of the greatest investors thinks.
I encourage everyone to have it one their summer reading list.
Disclosure: I wrote this article myself, and it expresses my own opinions. I have no business relationship with any company whose stock is mentioned in this article. The information provided should NOT be considered advice. The topics discussed are risky and have the potential to lose a substantial amount. I am not an investment professional and therefore do not offer individual financial advice. Please do your own research before investing.
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