The Little Book That Beats the Market

The Little Book That Beats the Market is a highly influential investment book written by hedge fund manager and professor Joel Greenblatt. Published in 2005, it was designed to be so simple that even a child could understand and apply its principles. The book introduces a quantitative investment strategy Greenblatt calls the “Magic Formula”. This formula provides a straightforward, mechanical method for buying good companies at cheap prices, effectively systematizing the core philosophy of value investing legends like Warren Buffett. Greenblatt’s goal was to empower ordinary investors with a tool that could consistently outperform the broader market over the long term, without needing a deep financial background. The book combines a folksy, easy-to-read narrative with back-tested data to demonstrate the formula's historical effectiveness, making a compelling case for a disciplined, numbers-based approach to stock picking.

At its heart, the Magic Formula is a screening process that ranks stocks based on just two simple, yet powerful, factors. It’s like a fishing net designed to catch only two types of fish: high-quality ones and bargain-priced ones. The stocks that rank highest on both measures are the ones you want in your portfolio.

How do you find a “good” company? Greenblatt argues it's one that can invest its money and get a high rate of return. A hot dog stand that costs $1,000 to set up and makes $500 a year is a better business than one that costs $1,000 and only makes $100. This concept is measured by Return on Capital. While there are many ways to calculate this, Greenblatt uses a specific version:

• Formula: EBIT / (Net Working Capital + Net Fixed Assets)

This formula essentially asks: for every dollar of capital tied up in the business's day-to-day operations and long-term assets, how much pre-tax profit does it generate? A higher return on capital suggests a more efficient and profitable company, often one with a strong competitive advantage.

How do you find a “cheap” company? You want to pay as little as possible for the company's earnings power. Greenblatt measures this with Earnings Yield. It’s like the inverse of the more famous P/E Ratio, but with a crucial twist. Instead of just using the stock price, Greenblatt's formula looks at the total price an acquirer would have to pay for the entire company, including its debt.

• Formula: EBIT / Enterprise Value

By using Enterprise Value (market value of equity + debt - cash), this metric provides a more holistic view of a company's price tag. A high earnings yield means you are getting a lot of earnings for the price you pay for the entire business. It's a more robust way to identify bargains than looking at the stock price alone.

Greenblatt lays out a clear, step-by-step process for implementing the strategy. The beauty of the formula is its mechanical nature, which helps remove emotion—an investor's worst enemy.

1. Step 1: Set a Minimum Size. Start with a list of stocks above a certain market capitalization (e.g., $50 million) to ensure you are dealing with reasonably liquid companies and not tiny, speculative ventures.
2. Step 2: Rank by Quality. Calculate the Return on Capital for each company and rank them from best (1st) to worst.
3. Step 3: Rank by Price. Calculate the Earnings Yield for each company and rank them from best (1st) to worst.
4. Step 4: Combine the Ranks. Add the two ranks together for each company. A company that ranked 10th on quality and 20th on price would get a combined score of 30. The companies with the lowest combined scores are your top candidates.
5. Step 5: Build a Portfolio. Buy a diversified portfolio of 20 to 30 of the top-ranked stocks over a year, adding 2-3 stocks each month.
6. Step 6: Hold and Repeat. Hold each stock for one year. After a year, sell the stock—reaping any profits or losses—and replace it with a new top-ranked stock from the updated list. This one-year holding period is designed to be tax-efficient by taking advantage of lower rates on long-term capital gains tax in the U.S.

While the Magic Formula is rooted in value principles, it’s important to understand its place within the broader value investing framework.

• Simplicity and Discipline: It provides a clear, unemotional, and easy-to-follow system. This is incredibly valuable for preventing behavioral biases like panic selling or chasing hot stocks.
• Strong Foundation: The formula is built on the timeless principles of buying quality businesses at attractive prices. It’s not a gimmick; it’s a systematized application of sound logic.
• Excellent Starting Point: For new investors, the Magic Formula is a fantastic educational tool and a powerful way to generate investment ideas.

• It's a “Black Box”: The formula tells you what to buy, but not why. A deep value investor would argue that you must understand the business, its competitive moats, the quality of its management, and its long-term prospects. The formula alone doesn't provide this qualitative understanding.
• Industry Blind Spots: The formula works best for standard manufacturing or service companies. It can produce strange results for financial institutions, utilities, or companies with unique capital structures, as their financial statements don't fit the mold.
• Patience is Required: Greenblatt himself emphasizes that the strategy will not work every year. There will be long periods (even 2-3 years) where it underperforms the market. Investors who lack the discipline to stick with it during these tough times will fail to see its long-term benefits, a phenomenon known as tracking error regret.

Ultimately, most seasoned value investors view The Little Book That Beats the Market not as a replacement for independent thought and thorough research, but as a phenomenal screening tool. It's an intelligent first filter to quickly surface a list of statistically cheap, high-quality companies that warrant a much deeper look.