Is there really a simple and systematic way to outperform the market? Throughout history, great investors like Benjamin Graham, Warren Buffett, and Peter Lynch have shown that it is possible, but usually with strategies that seemed too complex for the average investor.
In 2005, Joel Greenblatt changed the game by publishing The Little Book That Beats the Market. His approach was straightforward: a simple formula that anyone can apply in everyday life to invest in high-quality stocks at attractive prices.
Later, in 2010, he released The Little Book That Still Beats the Market, expanding and updating his ideas and confirming that the principles remain valid today.
Joel Greenblatt: An Unconventional Investor
Greenblatt is no ordinary theorist. He founded Gotham Capital in 1985 with just $7 million under management, much of it coming from friends and family. Over the next two decades, Gotham delivered an annualized return exceeding 40%.
In addition to being a fund manager, Greenblatt is a professor at Columbia Business School, the same institution where Benjamin Graham taught and Warren Buffett refined his ideas. What sets Greenblatt apart is his ability to distill complex concepts into accessible ideas.
His book, written as if he were speaking to his 12-year-old son, has achieved what few financial texts do: bringing value investing to millions of small investors.
The Essence of the Magic Formula
The formula combines two key metrics:
Return on Invested Capital (ROIC): Measures a company’s ability to convert the capital it employs into operating profits. In other words, it shows how efficiently each dollar invested in the business generates real earnings, reflecting the company’s quality and competitive advantage.
ROIC = EBIT / (Net Working Capital + Net Fixed Assets)
- The higher the ROIC, the better: it indicates a company with competitive advantages capable of generating more profit with fewer resources.
Earnings Yield: Indicates the return an investor earns relative to the company’s total price (Enterprise Value). In other words, it shows how much EBIT the company generates for every dollar invested, helping to assess whether a stock is cheap or expensive relative to its operating profits.
Earnings Yield = EBIT / Enterprise Value
- The higher the Earnings Yield, the cheaper the company.
Greenblatt’s strategy is simple:
- Rank companies by ROIC (highest to lowest).
- Rank companies by Earnings Yield (highest to lowest).
- Add both rankings and select the top companies.
The result: a list of profitable and undervalued companies.
Hypothetical Example
Imagine evaluating five companies:
| Company | ROIC | Ranking | Earnings Yield | Ranking | Total |
|---|---|---|---|---|---|
| A | 25% | 1 | 12% | 2 | 3 |
| B | 15% | 2 | 15% | 1 | 3 |
| C | 8% | 3 | 9% | 4 | 6 |
| D | 5% | 4 | 8% | 5 | 9 |
| E | 3% | 5 | 10% | 3 | 8 |
Company A is the most profitable (highest ROIC) and also cheap, ranking first in ROIC and second in Earnings Yield.
Company B has a lower ROIC than A but compensates by being the cheapest overall (first in Earnings Yield).
Both A and B tie with a total score of 3, making them the most attractive companies according to the Magic Formula.
Companies C, D, and E lag behind because they do not stand out in either metric.
This exercise demonstrates how the formula systematically prioritizes the best investment opportunities, combining quality and price without relying on intuition or emotion.
Historical Results
In his book, Greenblatt showed that applying this strategy in the U.S. market between 1988 and 2004 produced impressive results:
- The Magic Formula delivered an annual return of 30.8%.
- The S&P 500 returned only 12.4% over the same period.
While later studies show a narrower outperformance, the strategy still tends to beat the market over long-term horizons.
How to Apply It in Everyday Investing
Greenblatt designed this strategy so any disciplined investor could use it:
- Define the stock universe: In the U.S., he typically excluded very small companies (market cap < $50 million) and those in the financial and utility sectors.
- Select 20–30 stocks: Buy the top-ranked companies according to the formula.
- Invest gradually: Instead of buying all at once, purchase a few stocks each month to diversify over time.
- Hold each stock for one year: Then rebalance the portfolio by replacing positions with new top-ranked stocks.
- Exercise patience: Some years may underperform the market, but discipline pays off in the long run.
Criticisms and Limitations
Although powerful, the formula is not infallible:
- It may concentrate the portfolio in certain sectors (e.g., industrials or tech in a specific cycle).
- A high ROIC does not always indicate a durable competitive advantage; it could be temporary.
- It does not consider qualitative factors like management quality, regulatory environment, or macroeconomic risks.
- It requires confidence and patience, as long periods of underperformance are possible.
Does It Still Work Today?
Numerous subsequent studies, both academic and from investment firms, confirm that the strategy works, although returns are more moderate. It is not the “holy grail” of investing but remains a useful tool within a long-term value investing approach.
Additionally, it has inspired quantitative funds and ETFs that use similar selection criteria.
Conclusion: The True Magic
The true magic is not in the formula itself, but in providing investors a simple, systematic, and disciplined framework for value investing.
As Greenblatt says in his book:
“The secret is not in finding the magic formula, but in having the discipline to follow it.”
In a world where emotions and short-term news dominate investor behavior, the Magic Formula reminds us of the essentials: buy good businesses at attractive prices and hold them patiently.
However, no model replaces deep research. The formula is an excellent initial filter, but before investing, it is crucial to analyze financial statements, management quality, industry risks, and the macroeconomic context. Only by combining quantitative screening with rigorous qualitative research can investors make sound and sustainable investment decisions.
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