Back in 2005, Joel Greenblatt published The Little Book That Beats the Market. It’s slim, easy book that makes a big claim: anyone — even those without a finance background — could beat the market by following a simple set of rules. He named the system, and it is now widely known as, the Magic Formula.
Despite the name, there’s nothing mysterious about it. The “magic” is in its simplicity and discipline.
What is it
Greenblatt isn’t just an author — he’s a hedge fund manager and a long-time student of value investing. The formula he introduced was the product of years of experience, and it echoed principles many value investors already believed: that buying good businesses at fair or low prices tends to work over time.
But instead of relying on gut instinct or hours of company-by-company research, Greenblatt boiled the process down to two key metrics:
- Earnings Yield (EBIT / Enterprise Value), to measure how cheap a business is
- Return on Capital (EBIT / Net Working Capital + Net Fixed Assets), to assess how efficiently it turns investment into profit
You rank a universe of stocks by both metrics, combine those ranks, and invest in the top performers. It’s systematic. Quantitative. And surprisingly effective.
How it works
The method suggests buying around 20–30 of these top-ranked companies, spreading out the purchases over a few months, holding each for a year, and then rebalancing. That’s it.
There’s no forecasting involved, no narrative building. The formula doesn’t care if the company is in tech or textiles. It looks only at the numbers.
For many value investors, this removes a major hurdle: emotion. It’s not easy to stick with a strategy that underperforms for a year or two, but the formula helps by providing structure and rationale — it’s not about “feeling” like a stock is good; it’s about what the data says.
Does it work?
Historically, yes. Greenblatt showed strong long-term outperformance in his backtests, and others have replicated similar results. Like most value-based strategies, the Magic Formula can lag the market for extended periods. But over time, it has tended to outperform.
That said, it’s not foolproof. No system is. There’s always the risk of buying into a company that’s cheap for a reason. And the formula doesn’t incorporate qualitative factors like management quality or competitive moats — things many traditional value investors still care deeply about.
But as a starting point, or even a full strategy for someone looking to invest with discipline, it holds up well. Especially for those who want to remove some of the guesswork.
The Magic Formula is a structured way to apply value investing principles — buying good businesses at good prices — with consistency. For those who believe in fundamentals, and who are comfortable with a rules-based approach, it remains a compelling tool.
You don’t need to follow it blindly. But it’s worth understanding. At the very least, it reminds us that sometimes the best investing ideas aren’t the most complex — they’re just the ones we stick with.