The stock market can be a pretty intimidating place for new investors.
With all of its charts, ratios, and jargon, it’s clear why many people choose to either hire a professional to manage their stock portfolios or to ignore stocks altogether.
Does this sound like you?
If so, I’m glad you’re here, because, today, I’m going to show you a magic (and simple) formula for picking great African stocks.
Beating the Market with a Magic Formula
I wish I could take credit for it, but the system was actually developed by a much smarter investor than me.
Joel Greenblatt, a hedge fund investor and professor at Columbia University, first explained it in his excellent book, “The Little Book That Still Beats the Market.” It’s a great, quick read for anyone with even a passing interest in stock investing.
The formula has posted stellar results. According to research conducted by the American Association of Individual Investors, U.S. stocks selected according to the formula have outperformed the S&P 500, by an average of 7.6% per year over the past 15 years. Not too shabby, eh?
So, how does it work?
Essentially, the formula identifies profitable companies that trade at cheap prices. And it does it by using two simple ratios — the price earnings (P/E) ratio and Return on Assets (ROA).
Step 1: Calculate the P/E Ratio
The price earnings ratio (P/E ratio) is arguably the most common ratio in finance. There’s a reason for that. It’s one of the most straightforward methods to identify attractively-priced stocks.
Here’s how you calculate it:
P/E Ratio = Share Price ÷ Earnings Per Share
So, how do we interpret this ratio?
Well, if we are considering buying a stock, we want the share price to be low and the earnings per share to be high, correct? Of course! Because we want the most profit for the cheapest price.
Therefore, we should be on the lookout for stocks with low P/E ratios.
The chart below shows companies that trade on the Botswana Stock Exchange with their current share price and earnings per share. I’ve ordered them according to their P/E ratios (lowest to highest).
|Company Name||Share Price (Feb. 25, 2013)||Earnings per Share (TTM)||P/E Ratio||Score|
Therefore, based on the historic P/E ratio, FSG Limited appears to be cheap and Wilderness Holdings is expensive.
Step 2: Rank the Returns On Assets
Now, let’s look at the second part of Greenblatt’s magic formula — the return on assets (ROA).
Return on assets measures profitability. It tells us how much money a company earns per every dollar’s worth of assets that it owns.
Here’s the formula:
Return on Assets = Earnings ÷ ((Assets at beginning of period + Assets at end of period) ÷ 2)
We’re simply dividing earnings by the company’s average assets. Note that we use average assets because this figure can change significantly over the course of 12 months. [You can find all the data needed to complete this calculation in the company's most recent financial statement.]
The management of a company with a high ROA is typically making better use of the assets entrusted to it than the management of a company with a low ROA.
Moreover, companies with high ROAs will typically re-invest a portion of their profits in similarly profitable assets, creating a virtuous cycle.
Let’s take a look at how the Botswanan companies measure up according to this ratio.
|Company Name||Earnings||Assets (End)||Assets (Beginning)||ROA||Score|
It would appear that Sechaba Breweries generates more profit per dollar (or pula) of assets than any of the other companies here. That suggests that it can reinvest in expansion more quickly and more profitably.
Step 3: Time for Some Magic!
We’ve arrived at the final step of the magic formula. We’ve seen that, all things equal, it’s better to spend less for a dollar of earnings than more. We’ve also seen that, all things equal, its better to invest in a more profitable company than a less profitable one. So, let’s get the best of both worlds by investing in profitable companies that trade at bargain prices. To do this we simply add the P/E score to the ROA score to create a composite score for value and profitability.
|Company Name||P/E Score||ROA Score||Total Score|
There you have it. The magic formula points us to FSG Limited, Sechaba Breweries, and Chobe Holdings as potentially market-beating stock picks.
I’ve greatly simplified Greenblatt’s magic formula here. So, if you have any interest at all in screening for stocks, I highly recommend reading “The Little Book That Still Beats the Market (Little Books. Big Profits).” It’s an easy, entertaining read that distills all you really need to know about value investing.
Let Me Hear It
Do you think FSG, Sechaba, and Chobe will be among the Botswana Stock Exchange’s best performing stocks over the 12 months? Let us know why or why not in the comments!