The Little Book That Still Beats the Market Ch. 1: The Formula

"To get a high return on capital you must buy good companies — those with high returns on capital — and buy them cheap, at prices that give you a high earnings yield." — Joel Greenblatt

Investment Context

Joel Greenblatt founded Gotham Capital, which compounded at roughly 40% annually over two decades. He wrote The Little Book to demonstrate that successful investing requires neither elaborate financial models nor inside information.

His method — the magic formula — mechanises the idea of buying good businesses at fair prices. It ranks stocks on just two measures: return on capital (ROC) and earnings yield.

Worth noting: Greenblatt's own fund ran concentrated special-situation positions, nothing like the formula. He wrote the book not to describe what he does but to give people without time for deep research something executable instead.

The Wall Street Translation

Wall Street prefers complexity because complexity justifies fees. The magic formula shows that a mathematically trivial rule set can outperform most well-paid managers over long horizons.

1. A Machine That Excludes Emotion

The formula's chief advantage is removing human emotion from the decision chain entirely. You buy a stock not because the CEO gave a compelling presentation or the chart looks bullish, but purely because the rules say so.

2. Quality and Price Must Both Hold

Most investors optimise one side: growth investors chase quality, deep-value investors chase cheapness. The formula forces both, surfacing the small set of companies that are highly profitable yet temporarily disliked.

This contrasts sharply with Common Stocks and Uncommon Profits elsewhere in this library: Fisher demanded you understand business quality through interviews and scuttlebutt; Greenblatt argues quality can be approximated by a single financial ratio, which is what makes it executable by anyone. Fisher's approach is more precise, Greenblatt's more reproducible.

3. The Backtest and What It Actually Means

Over Greenblatt's 1988–2004 test, a 30-stock formula portfolio returned more than 30% annually — over double the S&P 500.

But understand what that number is: a backtest, not a live record, over a window that happens to cover one of the most favourable periods in US history for small-cap value. Chapter 5 examines how the formula actually performed out of sample.

Actionable Trading Rules

1. Use the existing screener: Greenblatt maintains magicformulainvesting.com, which runs the calculations and returns a ranked list — a usable starting universe.
2. Do not cherry-pick: If you adopt the formula, buy a basket of the top 20 to 30 names. It relies on statistical averages; individual holdings may fail, only the aggregate is meaningful.
3. Ignore your instinctive reaction: Many names on the list look terrible — litigation, earnings misses, bad press. That is precisely why they are cheap.

Relevance to a Retirement Portfolio

For retirees the magic formula is a satellite strategy sitting outside the core, never a replacement for low-cost index funds.

The sensible structure: keep the large majority in broad index funds and run a rules-based strategy like this with a small slice — for most people no more than 10% — accepting from the outset that it may trail the market for years at a stretch.