One question almost every investor asks is whether it's possible to achieve market returns by picking a diversified group of stocks based on a formula, as opposed to having to assess every single stock from every angle.
Several investment writers have proposed at least one such formulaic method during their lifetime. The most promising formulaic approaches have been articulated by 3 men: Benjamin Graham, David Dreman, and Joel Greenblatt.
As each of those approaches appeals to logic and common sense, they're not exclusive to these three men. But, these are the three names with which these methods are usually most closely associated; so, there's little need to draw upon sources beyond theirs.
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Benjamin Graham wrote 3 books: "Security Analysis", "The Intelligent Investor", and "The Interpretation of Financial Statements".
Within each book, he hints at various workable approaches both in stocks and bonds; however, he is most precise in his best known work, "The Intelligent Investor".
David Dreman is recognized as a contrarian investor. In his case, it can be an appropriate label, as a result of his keen interest in behavioral finance. Having said that, in most cases the line separating the value investor from the contrarian investor is fuzzy at best.
Dreman's contrarian investing methods are derived from three measures: price to earnings, price to cash flow, and then price to book value. Of these measures, the price to earnings ratio is certainly the most conspicuous.
Lastly, there's Joel Greenblatt's "magic formula". This is the most interesting formulaic approach for investing, both because it does not subject stocks to any true/false tests and mainly because it is a composite of the two most significant readily quantifiable measures a share has: earnings yield and return on capital.
As you might recall, earnings yield is simply the inverse of the P/E ratio; so, a stock with a high earnings yield is simply a low P/E stock. Return on capital may be thought of as the quantity of pennies earned for every dollar invested within the company.
The precise formula that Greenblatt uses is described in "The Little Book That Beats the Market". Greenblatt claims that his magic formula may be used in 2 different ways: as an automated portfolio generation tool or as a screen.
For an investor like you (that's, one with sufficient curiosity and commitment to frequent an internet site like this) the latter use could be the more appropriate one. The magic formula will serve you well as a screen.
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