One question almost every single investor asks is whether it's possible to achieve market returns by selecting a diversified group of stocks according to a formula, rather than having to evaluate every stock from every single angle.
Many investment writers have proposed at least one such formulaic strategy during their lifetime. Probably the most promising formulaic approaches have been articulated by three men: Benjamin Graham, David Dreman, and Joel Greenblatt.
As each of these approaches appeals to logic and common sense, they are not unique to these 3 men. But, these are the three names with which these strategies are usually most closely associated; so, there is little need to draw upon solutions beyond theirs.
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Benjamin Graham wrote three books: "Security Analysis", "The Intelligent Investor", as well as "The Interpretation of Financial Statements".
Within each book, he hints at numerous workable approaches both in stocks and bonds; on the other hand, he is most explicit in his best known work, "The Intelligent Investor".
David Dreman is known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest in behavioral finance. However, in most instances the line separating the value investor from the contrarian investor is fuzzy at best.
Dreman's contrarian investing techniques are derived from three measures: price to earnings, price to cash flow, and price to book value. Of these measures, the price to earnings ratio is by far the most conspicuous.
Finally, there is Joel Greenblatt's "magic formula". This really is the most interesting formulaic approach for investing, both since it does not subject stocks to any true/false tests and because it is a composite of the two most important readily quantifiable measures a stock has: earnings yield and return on capital.
As you'll recall, earnings yield is just the inverse of the P/E ratio; so, a stock with a high earnings yield is basically a low P/E stock. Return on capital may be thought of as the number of pennies earned for each dollar invested in the business.
The exact formula that Greenblatt utilizes is described in "The Little Book That Beats the Market". Greenblatt claims that his magic formula may be used in a couple of different ways: as an automated portfolio generation tool or as a screen.
For an investor like you (that is, one with sufficient curiosity and commitment to frequent a site such as this) the latter use may be the more suitable one. The magic formula will serve you well as a screen.
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