A Simple System to Stalk Super African Stocks

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
FSG Limited	1.35	0.20	6.75	9
Sefalana Holdings	3.75	0.52	7.22	8
RPC Data	0.25	0.03	7.65	7
Chobe Holdings	2.60	0.33	7.86	6
Furniture Mart	1.75	0.17	10.15	5
Sechaba Breweries	15.87	1.22	13.06	4
Choppies	2.4	0.12	20.46	3
G4S Botswana	5.82	0.23	25.75	2
Wilderness Holdings	2.28	0.06	40.07	1

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
Sechaba Brewery	161,676	250,117	224,132	68.2%	9
FSG Limited	33,168	174,035	145,263	20.8%	8
G4S Botswana	18,087	115,277	91,758	17.5%	7
Chobe Holdings	29,477	170,291	177,551	17.0%	6
Furniture Mart	104,481	774,948	698,463	14.2%	5
Choppies	129,430	1,085,111	823,849	13.6%	4
Sefalana Holdings	100,491	978,989	917,372	10.6%	3
RPC Data	2,250	27,272	17,923	10.0%	2
Wilderness Holdings	21,457	883,061	809,613	2.5%	1

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
FSG Limited	9	8	17
Sechaba Breweries	4	9	13
Chobe Holdings	6	6	12
Sefalana Holdings	8	3	11
Furniture Mart	5	5	10
RPC Data	7	2	9
G4S	2	7	9
Choppies	3	4	7
Wilderness Holdings	1	1	2

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!

Related Reading

How to Invest on the Botswana Stock Exchange

10 South African Stocks Poised to Beat the Market

Ranking Kenya’s Most Efficient Banks