The Little Book That Still Beats the Market by Joel Greenblatt

Book Summary

Presents the Magic Formula — a simple, systematic approach to buying good companies at bargain prices that has consistently beaten the market over long periods.

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Key Concepts from The Little Book That Still Beats the Market

1. Simple formulas can outperform complex investment strategies consistently: Joel Greenblatt's "magic formula" proves that some of the best investment strategies are surprisingly simple. His approach ranks every stock in the market using just two metrics: earnings yield (how cheap a stock is relative to its earnings) and return on capital (how efficiently a company uses its money to generate profits). By systematically buying the top-ranked stocks from this combined ranking, investors can potentially beat the market without needing complex financial models or insider knowledge. This concept matters because it directly challenges the Wall Street myth that successful investing requires sophisticated analysis and constant market monitoring. Most professional fund managers, despite their armies of analysts and expensive research tools, consistently fail to beat simple market index funds. Greenblatt's formula demonstrates that a mechanical, emotion-free approach often outperforms the gut feelings and complex strategies that lead most investors astray. Here's how it works in practice: imagine you're choosing between two companies. Company A trades at 10 times earnings (high earnings yield) and generates 25% returns on its invested capital. Company B trades at 30 times earnings (low earnings yield) but only generates 8% returns on capital. The magic formula would rank Company A much higher because it's both cheaper and more efficiently run. By focusing only on these fundamentals and ignoring market noise, news headlines, and emotional reactions, investors maintain discipline that's nearly impossible to achieve otherwise. The beauty of this systematic approach lies in its simplicity and consistency. While the formula may underperform in some years, Greenblatt's research shows it has historically delivered superior long-term returns precisely because it removes human psychology from the equation. When markets panic, the formula keeps buying undervalued, quality companies. When markets get euphoric, it avoids overpriced stocks that everyone else is chasing. The key takeaway isn't necessarily that everyone should follow Greenblatt's exact formula, but rather that simple, rules-based investing often beats complex strategies. Whether you use his magic formula or develop your own systematic approach, the real magic lies in creating a disciplined process that you can stick with through all market conditions, removing the emotional decisions that destroy most investors' returns. (Chapter 6)
2. High earnings per share price reveals undervalued opportunities: When most investors think about finding cheap stocks, they automatically reach for the price-to-earnings (P/E) ratio. However, Joel Greenblatt argues there's a much better way to identify truly undervalued companies: using earnings before interest and taxes (EBIT) divided by enterprise value. This approach gives you a clearer picture of what you're actually paying for a business, regardless of how it's financed. The magic lies in understanding what enterprise value represents – it's the total cost to buy the entire company, including both its stock price and its debt, minus any cash on hand. When you divide EBIT by enterprise value, you're essentially asking: "If I bought this whole business today, what annual return would I get on my investment?" This is far superior to the P/E ratio because it strips away the noise created by different capital structures and tax situations. Consider two identical retail companies, each generating $10 million in operating earnings. Company A has no debt and trades at a $100 million market cap, while Company B carries $40 million in debt but only has a $60 million market cap. Using P/E ratios, Company A might look cheaper, but the enterprise value approach reveals they cost the same to acquire – $100 million total. However, if Company B's enterprise value were only $80 million, you'd be getting a 12.5% earnings yield versus Company A's 10%, making it the superior bargain. This metric becomes especially powerful when comparing companies across different industries or with varying debt levels. A utility company loaded with debt might appear expensive using traditional P/E analysis, but could actually offer exceptional value when measured against its enterprise value. The key is focusing on the underlying business performance rather than getting distracted by financial engineering. The bottom line is simple: enterprise value-based analysis helps you think like you're buying the entire business, not just trading pieces of paper. This perspective naturally leads to better investment decisions because you're evaluating what truly matters – how much cash the business generates relative to what you're paying for it, debt and all. (Chapter 5)
3. Companies earning more on capital are superior investments: Think of capital efficiency like comparing two restaurants. Both might serve great food and make decent profits, but one restaurant generates $100,000 in annual profit using $500,000 worth of equipment and inventory, while another generates the same profit using $1 million in assets. The first restaurant is clearly the superior business because it's squeezing more earnings from every dollar invested. Joel Greenblatt's formula measures this efficiency by dividing EBIT (earnings before interest and taxes) by the total capital employed in the business. EBIT represents the company's operating profit, while the denominator includes net working capital (current assets minus current liabilities) plus net fixed assets like buildings and equipment. This ratio reveals how much operating profit a company generates for each dollar of capital it uses. Why does this matter so much for investors? Companies that earn high returns on capital have several powerful advantages. They can grow without constantly needing to raise money from investors or take on debt. They often have competitive moats – unique advantages that allow them to maintain their superior profitability. Most importantly, these businesses compound wealth more effectively over time because they can reinvest their earnings at high rates of return. Consider two hypothetical companies: TechCorp earns $50 million on $200 million of capital (25% return), while OldCorp earns $50 million on $500 million of capital (10% return). If both companies can reinvest half their earnings back into the business at their respective rates of return, TechCorp will grow much faster. After reinvesting $25 million at a 25% return, TechCorp adds $6.25 million in new annual earnings. OldCorp, reinvesting the same amount at 10%, only adds $2.5 million. The key takeaway is that capital efficiency often matters more than absolute profit size. A smaller company earning 20% on its capital will likely create more wealth for investors over time than a giant corporation earning just 5% on its capital. When evaluating investments, always ask: "How much profit does this business generate relative to the capital required to run it?" The companies with the highest ratios are often your best long-term bets. (Chapter 4)
4. Market beating strategies require years of disciplined execution: Imagine discovering a proven investment strategy that beats the market over the long term, but comes with a frustrating catch: it will disappoint you roughly one out of every three years, and sometimes underperform for two to three consecutive years. This is the reality Joel Greenblatt presents with his "magic formula" investing approach, and it highlights one of the most challenging aspects of successful investing – the need for unwavering discipline during periods of underperformance. The psychology behind this pattern is brutally predictable. When investors see their chosen strategy lagging the market for months or even years, doubt creeps in. They begin questioning whether the approach still works, whether market conditions have permanently changed, or whether they should switch to whatever strategy is currently outperforming. This emotional response is exactly what derails most investors from achieving long-term success, as they abandon ship just when their strategy is positioned to deliver strong returns. Consider what happened during the dot-com bubble of the late 1990s. Value investing strategies, including approaches similar to Greenblatt's formula, significantly underperformed as technology stocks soared to unsustainable heights. Many value investors endured three painful years of watching their disciplined approach get crushed by speculative momentum. Those who abandoned their strategy missed the subsequent market crash and the strong outperformance that followed when fundamentals mattered again. The key insight here extends far beyond any single investment formula. Whether you're following Greenblatt's approach, dollar-cost averaging into index funds, or implementing any other evidence-based strategy, success requires accepting that short-term underperformance is not just possible – it's inevitable. The investors who ultimately beat the market are those who understand this reality upfront and commit to staying the course during the uncomfortable periods. The most practical takeaway is to set realistic expectations before implementing any investment strategy. Know that your approach will likely underperform during certain market environments, prepare mentally for these periods, and focus on the long-term evidence rather than short-term results. Remember, if beating the market were easy and immediately gratifying, everyone would do it successfully. (Chapter 9)

About the Author

Joel Greenblatt is a renowned value investor, hedge fund manager, and professor who has built a distinguished career spanning over three decades in finance. He founded Gotham Capital in 1985, which achieved exceptional returns averaging over 40% annually for more than two decades before returning outside capital to focus on smaller sums. Greenblatt also serves as a professor at Columbia Business School, where he teaches value investing principles. Greenblatt is best known for his influential books on investing, particularly "The Little Book That Still Beats the Market" and "You Can Be a Stock Market Genius." These works distill complex investment strategies into accessible concepts for individual investors, with his "magic formula" combining low price-to-earnings ratios with high return on capital. His writing has made sophisticated value investing techniques understandable to mainstream audiences. His authority in investing stems from his proven track record managing billions in assets, his academic contributions at one of the world's top business schools, and his ability to generate consistent market-beating returns. Greenblatt's combination of practical experience, theoretical knowledge, and clear communication has established him as one of the most respected voices in modern value investing.

Frequently Asked Questions

What is the Magic Formula in Joel Greenblatt's book?

The Magic Formula is a systematic investment strategy that ranks stocks based on two metrics: earnings yield (how cheap a stock is) and return on capital (how good the business is). The formula identifies companies that are both high-quality and undervalued by combining these rankings to find the best investment opportunities.

Does Joel Greenblatt's Magic Formula actually work?

According to Greenblatt's research, the Magic Formula has consistently outperformed the market over long periods, generating average annual returns of 17.9% compared to the market's 12.4% from 1988-2004. However, the strategy requires patience as it may underperform for periods of 1-3 years before delivering superior long-term results.

How do you calculate earnings yield and return on capital?

Earnings yield is calculated as EBIT (earnings before interest and taxes) divided by enterprise value, which gives a better measure of cheapness than P/E ratios. Return on capital is EBIT divided by invested capital (working capital plus net fixed assets), measuring how efficiently a company generates profits from its invested capital.

What are the main criticisms of The Little Book That Still Beats the Market?

Critics argue that the Magic Formula's performance may not persist as more investors adopt it, and that it oversimplifies investing by reducing it to a mechanical formula. Some also question whether the historical backtesting results accurately predict future performance, especially in different market conditions.

How long should you hold Magic Formula stocks?

Greenblatt recommends holding Magic Formula stocks for at least one year, then selling and replacing them with new top-ranked stocks. This approach helps maintain tax efficiency while ensuring the portfolio stays focused on the highest-ranked opportunities according to the formula.

Is The Little Book That Still Beats the Market good for beginners?

Yes, the book is specifically written for beginning investors and uses simple language to explain complex investment concepts. Greenblatt provides step-by-step instructions and focuses on a straightforward strategy that doesn't require extensive financial knowledge or analysis skills.

What website does Joel Greenblatt recommend for Magic Formula screening?

Greenblatt created MagicFormulaInvesting.com to help investors implement his strategy by providing pre-screened lists of stocks ranked according to the Magic Formula. The website was designed to make the strategy accessible to individual investors without requiring complex calculations.

Why does the Magic Formula sometimes underperform for years?

The Magic Formula can underperform during certain market conditions when investors favor growth over value, or when market sentiment drives prices away from fundamental valuations. Greenblatt emphasizes that patience is crucial because the strategy's effectiveness emerges over longer time periods, typically 3-5 years or more.

What types of stocks does the Magic Formula avoid?

The Magic Formula typically excludes financial stocks, utilities, and foreign companies due to their unique capital structures and accounting methods. The strategy focuses on profitable companies and automatically filters out unprofitable businesses since they cannot be properly ranked using the earnings-based metrics.

Is there an updated version of The Little Book That Still Beats the Market?

The book has been updated since its original 2006 publication, with Greenblatt providing additional research and addressing common questions from readers. The core Magic Formula strategy remains the same, but updated editions include more recent performance data and practical implementation advice.

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