The Little Book That Still Beats the Market Chapter 2: Return on Capital

"A company that can earn a high return on capital is a company that has a special advantage over its competitors." — Joel Greenblatt

The Investment Context

The first half of the Magic Formula is designed to find a "good" business. Greenblatt measures "goodness" using a single metric: Return on Capital (ROC).

To explain this, he uses the analogy of "Jason's Gum Shop." If Jason spends $400,000 to build a gum shop, and the shop generates $200,000 in profit every year, his return on capital is 50%. This is a spectacular business. If another company spends $400,000 to build a store and only generates $10,000 in profit, the return is 2.5%. This is a terrible business.

The Wall Street Translation

Wall Street often focuses on aggregate growth (e.g., "sales increased by 20%"). Greenblatt argues that growth is worthless if it requires too much capital.

1. The Efficiency Metric: ROC measures how efficiently a company turns cash into more cash. A company with a 50% ROC can fund its own rapid expansion without ever needing to borrow money from a bank or dilute shareholders by issuing new stock.
2. The Moat Indicator: In a free market, if a company is earning a 50% return on capital, competitors will immediately try to copy them to steal those profits. If a company can maintain a high ROC over many years, it proves they have an economic moat (a strong brand, patents, or a monopoly) keeping competitors at bay.
3. The Ranking System: The Magic Formula calculates the ROC for every stock in the market and ranks them from 1 to 3,500. The company with the highest ROC gets a rank of 1.

Actionable Trading Rules

1. Calculate the ROC: Greenblatt defines Return on Capital as EBIT (Earnings Before Interest and Taxes) divided by (Net Working Capital + Net Fixed Assets). This tells you exactly how much operating profit the company generates from the hard assets required to run the business.
2. Avoid Capital Destroyers: Never invest in a company with a ROC below the risk-free interest rate (e.g., the yield on a 10-year Treasury bond). If a company earns a 3% return on its capital while a risk-free government bond pays 4%, the management team is actively destroying value.
3. Look for Consistency: A high ROC for one single year might be a fluke (e.g., a one-time spike in commodity prices). Look for companies that have maintained an ROC of 20% or higher for at least 5 consecutive years.