Ever heard of the price to book magic formula?
Are you a low price to book value investor? If you are you will definitely find this article, sent to me by one of our subscribers - Piero Marotta from Italy - of interest.
Piero has come up with an interesting investment strategy which combines a low price to book ratio with ideas of the Magic Formula.
Over to Piero…
I am a big fan of Joel Greenblatt. I have read all his books and have them in paper and a kindle version!
I went so far to download and print notes of his lessons in 2005 from a student at the Columbia University and also watched the videos of his lessons.
His style is engaging and his research and writing makes a very compelling argument to try his style of value investing in the real world.
However what I immediately realized after having listened to him is that if I have to be as smart as Joel to be successful in investing I'd better stop before I even started.
You do not have to be as smart
Luckily we don’t need to be that smart to do well in the market as long as we are consistent in implementing the strategies of value investing.
And we are strong enough to endure the inevitable periods of under-performance and draw-downs.
The principle of a cheap stocks and a good business
The most popular Greenblatt's strategy is the Magic Formula. I will not talk about as it has been the subject of countless articles and forums.
What I would like to focus on is the basic concept of the Magic Formula that investing in:
- Good businesses
- At bargain stock price
Will give us good returns on average.
In essence the strategy is: Get the best you can for what you are prepared to give.
What you give is the price you pay for the stock and what you get is an undervalued business.
How you define undervalued is a matter of choice, some investors focus on cash flow, others on earnings or dividends.
The Magic Formula with price to book
I prefer using the price to book ratio to find undervalued companies and will show you how you can combine a low price to book investment strategy with the Magic Formula.
Cheap stocks investment strategy
A classic value investing strategy is to buy a basket of stocks with a low price to book ratio.
Many books and research studies have demonstrated that a low price to book strategy returns, over the long term, a compound annual growth rate of around 10%.
In the chart below you can see the back tested returns for a low Price to Book investment strategy applied to European stocks.
Cheap and Good investment strategy
When combined with a metric that allows you to identify good businesses, such as Return on Equity (ROE) there is a big improvement of the returns, up to a 20% compound annual growth rate (CAGR).
This is a way you can get rid of bad companies that have a low price to book ration only because they have a low ROE.
Below is a chart that shows you the return of the high ROE low price to book investment strategy compared to only a low price to book strategy.
How to implement a high ROE low PB strategy
To implement this strategy you need to put together the following simple stock screen:
- As a first filter search for cheap companies by looking for low PB companies (use the book to market ratio to do this, here is why: Why use book to market and not price to book? )
- Use a second filter to search for good businesses with a high ROE
- This will give you a list of good companies at bargain price.
This is what my screen looks like:
Source: Quant investing screener
Click to enlarge
A better ranking system
This second ranking system is a bit more scientific.
It will allow you to rank the companies in the above screen based on the ratio between ROE and the price to book.
Put the same screen together as shown above.
Select at least the following columns:
- Close Price
- Price to Book
- Return on Equity
By clicking on the "Choose Columns" button.
Then click the Export to button and select Excel as shown below.
This is what the export to Excel looks like:
The next step is to insert a column here called BFB in which you divide ROE by PRICE TO BOOK ratio. This will give each company a value that combines ROE and price to book value.
Then sort the whole table in decreasing order by the BFB column as shown below:
For a company to rank well (have a high BFB value) it has to have a high ROE and low price to book values.
But a company with a low ROE can rank high if it has a really low price to book ratio. And if a company has a really high ROE it can have a higher price to book ratio and still rank high.
This ranking is especially useful because it allows you to buy only the best "quality" by "unit price of book" each month.
This is a really simple way you can easily implement a tested undervalued quality (cheap and good) investment strategy.
- Run the screen every month, buy the best ranked few companies and
- Re-balance after a year
Really interesting strategy
I am sure you will agree that Piero has put together a really interesting, market beating, investment strategy.
All this costs less than a lunch for two
How much can a tool like this to help you select market beating investment ideas cost, you may be thinking?
To make it affordable, and give you a great return on your investment, even if your portfolio is still small we have made the price of the screener very affordable.
It costs less than an inexpensive lunch for two each month (Click here for more information).
Don’t hesitate, you really have nothing to lose - if you are not 100% satisfied with the screener you get all your money back – guaranteed!
Wishing you profitable investing
PS: Why not sign up now, while this is fresh in your mind?
Why use book to market and not price to book?
How to implement a low price to book investment strategy – world-wide
Price to Book & Price Index 6m investment strategy