The Little Book That Still Beats the Market Chapter 1: The Formula

"To earn a high return on capital, you have to buy good companies (ones that have a high return on capital) and to buy them at bargain prices (at prices that give you a high earnings yield)." — Joel Greenblatt

The Investment Context

Joel Greenblatt, founder of Gotham Capital (an investment partnership that achieved an astonishing annualized return of 40% over two decades), wrote The Little Book That Still Beats the Market to prove that successful investing does not require complex financial modeling or insider information.

Instead, he proposed a simple, systematic method known as the Magic Formula. The goal of the formula is to execute Warren Buffett's philosophy—"buying a wonderful business at a fair price"—mechanically. The formula ranks stocks based on only two metrics: Return on Capital (ROC) and Earnings Yield.

The Wall Street Translation

Wall Street loves complexity because it justifies high fees. The Magic Formula proves that a mathematically simple, rules-based system can drastically outperform highly paid hedge fund managers.

1. The Emotionless Machine: The primary advantage of the Magic Formula is that it completely removes human emotion from the investment process. You don't buy a stock because the CEO gave a great interview or because the chart looks bullish. You buy it purely because the math dictates it.
2. Quality + Price: Most investors look for either quality (growth investors) or price (deep value investors). The Magic Formula forces you to look for both simultaneously. It finds the rare companies that are highly profitable but temporarily hated by the market.
3. The Index Beater: In Greenblatt's historical backtests spanning 17 years, a portfolio of 30 stocks selected by the Magic Formula returned over 30% annualized, more than double the return of the S&P 500 over the same period.

Actionable Trading Rules

1. Use the Screener: Greenblatt created a free website (magicformulainvesting.com) that automatically runs the math and provides a list of the top 30 to 50 stocks based on the formula. Use this as your primary hunting ground.
2. Commit to the System: If you choose to use the Magic Formula, you cannot cherry-pick. You must buy a basket of 20 to 30 of the highest-ranked stocks. The formula relies on statistical averages; some individual picks will go bankrupt, but the overall basket will thrive.
3. Ignore Your Gut: When you look at the list of Magic Formula stocks, many of them will look terrible. They will be companies facing lawsuits, temporary earnings misses, or negative news cycles. That is why they are cheap. You must ignore your instinct to avoid them.