Savvy Nickel
by Joel Greenblatt
Joel Greenblatt's magic formula investing system ranks stocks by earnings yield and return on capital to systematically find cheap, high-quality businesses. Backtested to beat the S&P 500 by 7+ percentage points annually over 17 years.
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Joel Greenblatt ran the Gotham Capital hedge fund from 1985 to 1994, averaging 40% annual returns. After returning capital to outside investors, he spent years developing a systematic formula that could replicate the core logic of value investing without requiring deep security analysis. The result is the "magic formula" — a two-factor ranking system using earnings yield and return on capital. The book that describes it is one of the best investing books ever written, accessible enough for a teenager while rigorous enough to change how professionals think about systematic value.
| Attribute | Details |
|---|---|
| Title | The Little Book That Still Beats the Market |
| Author | Joel Greenblatt |
| Publisher | Wiley |
| Published | 2005 (Updated 2010) |
| Pages | 218 |
| Reading Level | Beginner to Intermediate |
| Amazon Rating | 4.6/5 stars |
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Joel Greenblatt founded Gotham Capital in 1985 with $7 million. He averaged 40% annualized returns over the next decade — one of the best records in hedge fund history. He later founded Gotham Asset Management and teaches the adjunct value and special situations investing class at Columbia Business School, continuing the tradition of Graham and Greenwald.
His book You Can Be a Stock Market Genius (1997) covers his specialty in special situations (spinoffs, mergers, restructurings). This book is his attempt to distill value investing into a formula anyone can follow.
Greenblatt uses earnings yield rather than P/E ratio because it allows direct comparison across companies with different capital structures:
Earnings Yield = EBIT / Enterprise ValueWhere:
Using EBIT (rather than net income) removes the effect of debt financing. Using enterprise value (rather than market cap) accounts for the full capital structure.
Why this is better than P/E:
| Company | Market Cap | Net Income | P/E | EBIT | Enterprise Value | Earnings Yield |
|---|---|---|---|---|---|---|
| A (no debt) | $100M | $10M | 10x | $14M | $100M | 14% |
| B (heavy debt) | $100M | $10M | 10x | $14M | $200M | 7% |
Company B looks identical to A on P/E but is half as attractive because you are paying $200M for the same $14M in operating earnings. Earnings yield captures this correctly.
Return on Capital = EBIT / (Net Fixed Assets + Net Working Capital)This measures how efficiently a business converts its invested capital into earnings. High ROIC businesses require less capital to grow — they compound more efficiently.
ROC interpretation:
| ROC | Business Quality |
|---|---|
| Below 10% | Below cost of capital; value-destroying |
| 10-15% | Average business |
| 15-25% | Good business |
| 25-40% | Excellent business |
| Above 40% | Exceptional franchise |
Greenblatt's magic formula:
The logic: This systematically finds businesses that are both cheap (high earnings yield) and good (high return on capital). Graham found cheapness. Buffett found quality. The magic formula finds both simultaneously.
Greenblatt backtested the formula from 1988 to 2004 on the 3,500 largest U.S. stocks:
| Time Period | Magic Formula Return | S&P 500 Return |
|---|---|---|
| 1988-2004 (17 years) | 30.8% annually | 12.4% annually |
| Rolling 1-year periods | Beat market in 76% | - |
| Rolling 3-year periods | Beat market in 95% | - |
| Rolling 5-year periods | Beat market in 97% | - |
The cumulative impact:
| $10,000 Invested | 17 Years at 30.8% | 17 Years at 12.4% |
|---|---|---|
| Ending value | $1,003,000 | $71,600 |
The formula produced 14x the wealth of the index over 17 years.
Greenblatt explains that the magic formula works precisely because it is painful to follow. In any given year, the formula underperforms the market approximately 1 in 4 years. Over 2-3 year periods, it underperforms roughly 1 in 20 times.
This intermittent underperformance causes most investors to abandon the formula during losing stretches, which reduces competition and preserves the premium.
The behavioral paradox:
"The formula works because it doesn't always work. If it always worked, everyone would use it and the premium would disappear."
Use magicformulainvesting.com (Greenblatt's free website):
Tax efficiency:
For taxable accounts, hold winners slightly past the one-year mark (long-term capital gains rate) and sell losers slightly before the one-year mark (short-term loss for maximum tax benefit).
Greenblatt acknowledges the formula is improved by adding simple qualitative screens:
The last filter is the most important. If a company is cheap because its industry is structurally declining (print newspapers, physical retailers facing Amazon), the low ranking is a warning, not an opportunity.
Greenblatt explains stocks as ownership in real businesses with impressive clarity:
"When you own a share of stock, you own a proportionate share of a business. That means you're entitled to your share of all the earnings that business generates in the future."
He uses a small business example: if you bought a store that earned $1,200 per year for $6,000 (5 P/E), that is a 20% earnings yield. You can evaluate whether that is a good price by comparing it to alternatives (savings account at 3%, bonds at 5%, other stores at different prices).
This reframing — stocks as pieces of businesses with definable earnings yields — cuts through the noise of market commentary.
Greenblatt's version of Graham's Mr. Market allegory for younger readers:
He describes a business partner who offers to sell you his half of the business at a new price every day. Some days the price is very high; some days very low. You can either buy more of the business, sell your share, or ignore him.
The key: the daily price changes do not change the value of the underlying business. Only the fundamentals of the business change its value. Mr. Market's mood is irrelevant unless you choose to trade with him.
The magic formula has received academic scrutiny since publication:
Studies on post-publication performance:
| Study | Period | Finding |
|---|---|---|
| Gray & Vogel (2012) | 1964-2011 | Magic formula beats market by 5%/year |
| Carlisle (2012) | 1970-2010 | Earnings yield alone beats combined formula |
| Greenblatt's own Gotham funds | 2009-2023 | Gross alpha of 3-5% annually (net fees lower) |
The formula continues to generate excess returns, though smaller than the original backtest period. Greenblatt himself evolved toward more sophisticated implementations (long/short, concentrated positions) in his Gotham funds.
The formula can underperform for multiple years. During the 2010-2019 period of growth stock dominance, value-oriented approaches including the magic formula significantly underperformed the S&P 500. Investors who started in 2013 and judged the formula after 5 years might have abandoned it just before its recovery.
Sector concentration. The formula often concentrates in cyclical sectors (energy, financials, retailers) that happen to have high earnings yields at cyclical peaks. These are sometimes value traps.
It buys cheap quality, not the cheapest. Pure earnings yield (without the quality filter) has historically outperformed the combined formula in some academic studies. The quality screen may actually reduce returns slightly by excluding the cheapest stocks.
Small cap concentration. The formula works best in small and mid-cap stocks, where institutional inefficiency is greatest. In large caps, the formula's edge is smaller.
Q: Does the magic formula still work today?
A: Academic evidence suggests yes, though with smaller excess returns than the 1988-2004 period. The premium from systematic value investing persists, likely because the behavioral challenges of maintaining the discipline preserve it.
Q: Can I implement it in a Roth IRA?
A: Yes, and this is ideal. Tax-free growth eliminates the annual capital gains friction from portfolio turnover. The formula works best in tax-advantaged accounts.
Q: What is the minimum capital needed?
A: To own 20-30 positions with meaningful amounts, approximately $10,000-$20,000 is practical. Below that, transaction costs eat into returns.
Q: Is there an ETF that implements the formula?
A: Greenblatt's Gotham funds implement variations of the strategy. Several value ETFs (QVAL, IVAL) implement similar factor combinations. These provide the exposure without the transaction costs of individual stock management.
Rating: 4.6/5
The Little Book That Still Beats the Market is the clearest explanation of systematic value investing ever written. Its magic formula is genuinely effective, its explanation of earnings yield is unsurpassed in accessibility, and its honest discussion of behavioral challenges makes it more useful than most books that oversell their strategies. Essential reading for any investor considering a rules-based value approach.
Hardcover: Buy on Amazon
Kindle: Buy on Amazon
Audiobook: Buy on Amazon
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