In The Little Book That Beats the Market (2005), hedge fund manager Joel Greenblatt boiled value investing down to two numbers. His point: a simple, mechanical rule followed patiently beats most people’s gut feel, mainly because it removes emotion.
How the Magic Formula works
- Return on capital: operating profit (EBIT) divided by the capital the business needs to run (working capital plus fixed assets). High means a good business.
- Earnings yield: EBIT divided by enterprise value (market cap plus net debt). High means a cheap price.
- Rank every company on each, add the two ranks, and buy the top 20 to 30, a few at a time through the year.
- Hold each for about a year, then repeat. Greenblatt left out financials and utilities, whose accounts don’t fit the formula.
Good business, cheap price: the same idea as Buffett’s, reduced to arithmetic.
Where it trips up
- Peak earnings look cheap. A cyclical company at the top of its cycle has a high return on capital and a high earnings yield, right before both fall.
- One year is arbitrary. A bargain can take longer than a year to be recognized, or be recognized in a month.
- Debt and cash are only half-seen. Enterprise value counts debt in the price, but nothing checks whether the company can carry it or whether profits turn into cash.
- It can lag for years. Greenblatt is open that the formula went through long stretches of losing to the market, which is when most people quit.
A stricter version
The rule on this site starts from the same pair, quality and cheapness, but values each company with a cash-flow model from its own filings instead of one ratio. It also demands real profits and positive cash earnings, net debt under 3.5× operating income, and no cyclicals at peak margins (the full methodology). It keeps financials and utilities, valued with models that fit them. It re-checks daily and sells when the price reaches fair value rather than on a calendar date.
Today 55 of 499 companies pass. The model portfolio holds the top 15, and its record against the S&P 500 is public.