Investing Finance Business

The Little Book That Still Beats the Market (Summary)

by Joel Greenblatt

What if you could consistently beat the world's best investment managers using a simple, two-step formula that a sixth-grader could understand and apply in minutes? Hedge fund manager Joel Greenblatt not only developed this 'Magic Formula' but back-tested it to the Great Depression, proving that it systematically trounces the market averages over the long run.

The Magic Formula: Goodness and Cheapness

The entire strategy boils down to ranking companies on just two metrics: Return on Capital (which identifies good, efficient businesses) and Earnings Yield (which identifies cheap, undervalued businesses). By buying a portfolio of the companies that rank highest on a combined basis, you stack the odds in your favor.

Think of Return on Capital like this: if you buy a gumball machine for $1,000 (the capital) and it generates $500 in profit per year, that's a 50% return—a great business. Earnings Yield asks how much profit the business generates relative to its price. If a company earns $1 per share and its stock price is $10, it has a 10% earnings yield. The formula simply finds companies that are both great gumball machines and on sale.

Treat the Market Like Your Manic-Depressive Partner

Borrowing from his mentor Benjamin Graham, Greenblatt explains that the stock market is like a moody business partner named 'Mr. Market.' Some days he's euphoric and offers to buy your shares at absurdly high prices. Other days he's deeply depressed and offers to sell you his shares for pennies on the dollar. You don't have to listen to him—you just have to take advantage of his irrationality.

If Mr. Market shows up panicked about a temporary news headline and offers to sell you shares in a great company for 50% off its normal price, you should happily buy. If he later shows up ecstatic about the same company and offers to buy them back for double what they're worth, you sell. The key is to let his mood swings serve you, not influence you.

The Formula Works Over Time, Not All the Time

The single biggest reason people fail with the formula is impatience. The strategy is designed to work over a multi-year period, but it can and will underperform the market for months or even a year or two at a time. Sticking with the process through these tough periods is essential for success.

Greenblatt's back-tests show that while the formula dramatically beat the S&P 500 over 17 years, it actually underperformed the market in one out of every four of those years. An investor who gave up during a down year would have missed the powerful long-term average that makes the strategy so effective.

You Don't Need to Predict the Future

The magic of the formula is that it removes emotion and guesswork. Instead of trying to predict which industry will be hot or which CEO is a genius, you rely on a systematic, data-driven process that tilts the odds in your favor over and over again.

Rather than trying to calculate the precise intrinsic value of Coca-Cola, the formula simply takes 3,000+ companies and ranks them. It says, 'Out of this whole group, here are the 30 that appear to offer the best combination of quality and price right now.' By buying this basket, you diversify your bets across a group of statistically attractive opportunities.

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