When I read The Little Book That Still Beats the Market by Joel Greenblatt, I really enjoyed it. I read it in one day; it was only 3 hours of reading. The book is very didactic and uses a humorous way to explain Joel Greenblatt’s magic formula.
In this post, I’m going to talk a little about the book and the magic formula it describes. My intention is not to summarize the book, but to pick up the interesting parts.
Before trying to apply Joel’s magic formula, it is essential that you read the book to understand it and the possible flaws, as the author himself says. According to him, more important than using the formula is understanding how it works and why it makes sense.
Who is Joel Greenblatt?
Joel Greenblatt is one of the most successful investors of all time. He is also an academic, and he has taught value investing at Columbia Business School since 1996.
Joel founded the hedge fund Gotham Capital in 1985 and has run it ever since.
The Little Book That Still Beats the Market
The book is small (it has “little” in the title), and it took 3 hours to read. Joel is very didactic and presents the information in a simple and fun way.
He explains the ideas using a made-up gum shop as an example.
He talks a lot about choosing profitable companies with a low price (bargain). And it is simply on these two principles that he bases his “Magic Formula”.
Joel Greenblatt’s Magic Formula
The main objective of the formula is to “find good companies for a low price”.
The Magic Formula is a ranking formula that ranks good companies with low prices. For this, two classifications are made based on two factors: return on capital and earnings yield.
In the book, Joel tested a portfolio of 30 stocks chosen by the formula from 1988 to 2009, replacing them each year with the new top 30. It returned 23.8% a year, while the S&P 500 returned 9.5% a year over the same period.
An important detail is that according to the author, the formula works best with a portfolio of 20 to 30 stocks. Many of the stocks in the portfolio underperformed the market but on average the portfolio was above.
Good companies (return on capital)
First, the author indicates that good companies should be classified. In this case, the criterion is the return on capital. That is, how much a business earns on the capital invested in it.
The higher the return, the better.
In the step by step, the author recommends using ROA (Return on Asset) but in the appendix, he uses the following formula: EBIT / (net working capital + net fixed assets).
Low price (earnings yield)
By definition, a bargain is something you buy at a lower price than it is worth. Companies with greater discounts, or a bigger margin of safety, as Graham calls it, are more likely to produce good returns.
For the low price criterion, Joel mentions that Price/Earnings (P/E) can be used ordered from lowest to highest. In the appendix, he uses EBIT/Enterprise Value instead.
I personally don’t follow the Magic Formula, I am more an investor in Compounder Companies rather than a Value investor. But either way, it is good to know the formula to understand its advantages and drawbacks.
Happy investing!
Photo by Erwan Hesry on Unsplash