One question almost every single investor asks is whether it really is possible to achieve market returns by choosing a diversified group of stocks in accordance with a formula, as opposed to having to evaluate each and every stock from every single angle.
Lots of investment writers have proposed at least 1 such formulaic method during their lifetime. Probably the most promising formulaic approaches have been articulated by 3 men: Benjamin Graham, David Dreman, as well as Joel Greenblatt.
As each of those approaches appeals to logic and common sense, they are not exclusive to these 3 men. But, they are the 3 names with which these methods are usually most closely related; so, there's very little need to draw upon sources beyond theirs.
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Benjamin Graham wrote 3 books: "Security Analysis", "The Intelligent Investor", as well as "The Interpretation of Financial Statements".
Inside of each book, he hints at several workable approaches both in stocks and bonds; on the other hand, he's most specific in his best known work, "The Intelligent Investor".
David Dreman is identified as a contrarian investor. In his case, it can be an appropriate label, because of his keen interest in behavioral finance. Having said that, in most instances the line separating the value investor from your contrarian investor is unclear.
Dreman's contrarian investing methods are derived from 3 measures: price to earnings, price to cash flow, and then price to book value. Of those measures, the price to earnings ratio is certainly the most conspicuous.
Finally, there's Joel Greenblatt's "magic formula". This really is the most intriguing formulaic method for investing, both since it doesn't subject stocks to any true/false tests and simply because it's a composite of the two most significant readily quantifiable measures a stock has: earnings yield and return on capital.
As you may recall, earnings yield is just the inverse of the P/E ratio; so, a stock having a substantial earnings yield is basically a low P/E stock. Return on capital might be thought of as the quantity of pennies earned for every dollar invested within the business.
The precise formula that Greenblatt utilizes is described in "The Little Book That Beats the Market". Greenblatt states that his magic formula may be applied in 2 different ways: as an automated portfolio generation device or as a screen.
For an investor like you (that's, one with enough curiosity and commitment to frequent an internet site such as this) the latter use may be the more suitable one. The magic formula may serve you well as a screen.
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