Sunday, August 21, 2011

Lesson 4: The Magic Formula

Many of us would be delighted to get ahold of a magic formula to make money. I have good news. There is such a formula. And I am going to tell you what it is. Wait... someone just told me to stop. He doesn't want to hear it. He thinks I'll just be wasting his time. He just asked me a question... If there is really a magic formula, why isn't everyone using it to get rich? And why would I give out such a secret?


Good question. It's a good question because generally, if it sounds too good to be true, it usually is. But it's actually a bad question. It's a bad question to ask. Whoever asks such a question believes that we were all created equal, and that if someone can do something 'difficult', then anyone, with enough learning or training, can eventually achieve it too. Great news! We are not all created equal. It would be pretty hard to do better than someone else if they all worked as hard as you. The traits that will most define our success are motivation and perseverance. And everyone happens to have a different amount. The very fact that you reading my article has already set you ahead of the 90% of the world who would rather be watching American Idle. (Yes, I meant to spell it that way)

Let's move away from stocks and investing for a bit. Imagine you were tasked with building the world's fastest car. You have to travel in a straight line in the shortest amount of time. How would you do it? Is there a magic formula? Yes! It's quite simple. You want to maximize your acceleration and maximize your top speed, and find a combination of the two which will minimize the required time. Sounds simple enough right? The formula is pretty simple. So how many of you can potentially build the fastest car? Less than 1 percent of you would actually be able to do it. The formula is simple. Achieve the highest acceleration and maximum speed, and minimize the amount of time. If I tell you that you'll need to use derivatives (the math kind) it doesn't sound so simple anymore. Minimizing the time by optimizing the acceleration and top speed parameters require the use of calculus. Understanding how torque affects acceleration and how cross-sectional area affects air resistance requires calculus AND physics. Optimizing those numbers requires you to take the weight of the engine and power output into account. Even after you've gone through all of this learning, you need to build the damn thing. That is a completely different field altogether.

This is the magic formula, for building the fastest car. You can tell it to anyone, and not worry about anyone building a faster car that you. In fact, it's so simple that anyone could figure it out for themselves. However, to utilize the formula requires that you have a full understanding of what the formula actually means.

Now, for the moment of truth. I can tell the magic formula to the world, and not worry about it no longer being profitable. The fact is, this magic formula is something that all successful investors understand, in some shape or form. So here it is.

1) Invest in a high return on equity.
2) Invest in at an attractive price, aka low Price to Earnings ratio.

We'll go more into detail on these two points in different articles. What it comes down to is that you should buy something which can generate a lot of money at a low cost. It's not enough to filter a list of stocks for high return on equity and low P/E ratios. That would be a starting point. That would be a decent starting point, because you will manage to filter out the egregious companies with dynamite strapped to its underpants. However, that won't remove the ones who by random chance or intensional manipulation will fit that criteria. A P/E ratio, as simple as it is, is pretty meaningless if you don't understand how earnings are calculated. To know how to calculate earnings, you need to understand accrual accounting, depreciation, inventory, debt, liabilities, cashflow, stock repurchases and so on. If a company has manipulated the Earnings, how reliable is the P/E ratio?

Let me help you learn it. If you're willing to spend the time to learn, I'm willing to spend the time to teach. My hope is that in the future, you will surpass me and we can learn from each other, and help each other in finding opportunities, and verify each other's work. I am selfish and my motive is selfish. However, I am just smart enough to understand that a little bit of sharing can end up benefitting me even more. And it's alright with me if you end up a little better off than where you started.

3 comments:

  1. I like your articles, easy to read and you make the subject easy to understand. Hope you upload more of these because I've just bookmarked your page.

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    Replies
    1. Glad you like them. If you have any topics that you'd like me to discuss, feel free to ask!

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    2. Will do, just making my way through your lessons and other articles. I suspect I will have a few things to ask

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