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5 Steps for Getting Started in Magic Formula Investing in 2009

The new year is here, a time for reflection on the past year and getting things in order for the year ahead. For many people and families, one of the top resolutions is to get their finances in order and begin saving for the long term goals of retirement, a child or grandchild's college expenses, a new home, and so on. But there is so much financial advice out there that it can seem overwhelming just getting started.

So in the interests of helping those looking for guidance, here is a 5 step checklist for getting started with Magic Formula Investing in 2009:

  1. Pay off all short term credit obligations. Before even considering investing, you should make sure all revolving credit card debt is paid off. Interest rates on these are nearly 10% even for prime customers, around 18% for most, and over 20% for those with weaker credit. It takes an extremely successful investor to constantly earn returns like this on stock investments. Use excess cash first to clear these high rate debts. In addition to credit cards, consider also paying off high rate auto loans if the outstanding balance is relatively low and the interest rate is high (8% or higher).

  2. Establish an emergency cash fund. Most financial planners advocate having 4-6 months living expenses in a savings account as an "emergency fund". Allocate cash to establishing or funding this account before even thinking about stocks. This backstop is critical in the case of losing one's job or facing unpredictable expenses, such as a medical emergency or large home or auto repairs. Sit down and figure out what your core living expenses are per month, multiply that by 4, and set aside at least that much cash in a savings account. You should even be able to earn a fair interest rate if you shop around some.

  3. Read The Little Book that Beats the Market by Joel Greenblatt. This book is the "bible" of Magic Formula Investing. Greenblatt's short book can be read in about 2-3 hours, can be easily understood even by those with little investing experience, and forms the basis for the research performed at MagicDiligence. This simple strategy has been proven to vastly outperform the market and is easy to implement.

  4. Open a low or no-fee brokerage account. Magic Formula Investing (MFI) is a rather high turnover strategy (the portfolio is completely replaced over the course of a year). This means there is a fair amount of trading involved. Most brokerages charge a commission whenever a buy or sell trade is placed. These charges can add up and eat into profits. Luckily, several very low cost Internet brokers have popped up over the last couple of years that can reduce or eliminate this nuisance. The favorite here is Zecco, an online brokerage that charges $0 commissions for account balances over $2,500 (as of this writing, up to 10 trades a month):

    Free Stock Trade. Trade stocks for free on Zecco.com. The Free Trading Community. www.zecco.com

  5. Choose MFI stocks with durable competitive advantages. Though Magic Formula Investing usually turns up very attractive investment opportunities, there are potholes in the screens it creates. Several MFI stocks in 2008 lost over 90% of their value even after appearing on the screen, and 3 of them went bankrupt. Many experienced investors have expressed the opinion of MFI being a very good strategy, but also needing additional research to weed out the value traps. Look for MFI stocks with low debt loads, strong free cash flows, and 5 years or more of high return on capital (return on equity, assets, or invested capital). This will help separate the truly great companies with durable competitive advantages from the fad stocks, cyclical commodity stocks, and dying businesses. This research can also be obtained by trying a free 30-day trial MagicDiligence Membership, where you can read all current and past research on Magic Formula stocks, including the Top Buy recommendations of the very best companies on the screen. Some free examples are available here.

Following these steps will put you in a very strong financial position to weather the storms of life and build wealth for 2009 and beyond!

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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Comments

Posted by cookedc on 2009-01-07 22:23:13

Steve,

A few comments:

Nice article. I agree with your five points.

What disadvantage do you see with Zecco vs. TD Ameritrade? I have been with Ameritrade for several years and it seems to work well for me, although the commissions at ten buck a pop do add up over time and to do a MFI stragy, one really needs to have at least $50K to invest, and better if at least $100K to keep the commission percent relatively low. Also, do you think you should mention that Zecco pays you money to advertise on your website? That should be obvious since the ads are prominent, but it might help your credibility if you explicitly mention that. Kind of reminds me of how Jim Cramer continually plugs Hewlett-Packard Company stock when the company advertises heavily on Jim's web site The Street.com.

Second, I have been a subscriber to MagicDilligence for several months and have enjoyed the valuable commentary and like the fact that you steer me away from many bad MFI companies, and toward top buys.

One thing that takes me a lot of time is to read the updates on companies, since the text that you update isn't separated from the content you kept in there from last time. For example, for today's BBBY (Bed, Bath and Beyond) update I wasn't sure what was new info and what is old info. [Also I notice that you still indicate near the bottom of the text that it's a top buy, when you have pulled it off that list. Wondering if you still own it as you indicate near the bottom.]

Thanks again for the valuable service of MD. If you could somehow highlight the new info in the quarterly updates that would be very helpful. Maybe put the new stuff in a different color font.

Keep up the good work,
David

Posted by Steve on 2009-01-08 05:35:30

David - thanks for the comments! Yes, Zecco is an affiliate, I've mentioned that in a few articles and as you said the ads are prominent. I have found a few disadvantages with Zecco against Ameritrade or E*TRADE. Their website is slow loading, sometimes clicking a link doesn't do what you think it should do, you get no free research (E*TRADE gives you S&P and other reports), few screening tools, etc. It's pretty bare bones.

On the updates, the stock research page always contains the latest update at the top, followed by the point-by-point research. You can click on the "Updates" link (on the right hand side) to get a list of all updates, ordered chronologically from latest to oldest.

Hope this helps, and thanks again!

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