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The Little Book That Still Beats the Market

by Joel Greenblatt (2010)

Quick summary -- an in-depth PhD-level extended summary (10-30 pages) for this book is coming soon.

The Little Book That Still Beats the Market

Author: Joel Greenblatt | Categories: Value Investing, Beginners

Executive Summary

"The Little Book That Still Beats the Market" by Joel Greenblatt presents a deceptively simple investing strategy called the "Magic Formula" that systematically identifies good companies selling at bargain prices. Greenblatt, founder of Gotham Capital (which achieved annualized returns of 40%+ over two decades), distills value investing principles into a formula accessible enough for an 11-year-old to understand. The Magic Formula combines two metrics -- earnings yield and return on capital -- to rank stocks, creating a systematic approach to value investing that backtests show has dramatically outperformed the market over extended periods.

Core Thesis & Arguments

Greenblatt's central thesis is that the stock market is not perfectly efficient, and a simple, systematic approach to buying good businesses at cheap prices can consistently beat the market. His key arguments: (1) The market is reasonably efficient most of the time but periodically offers bargain prices due to emotional overreaction; (2) Buying above-average companies at below-average prices is the essence of successful investing; (3) A formula-based approach removes emotional bias from investment decisions; (4) The Magic Formula works precisely because it requires patience and discipline that most investors lack; (5) Even if widely known, the formula will continue to work because investors' emotional biases prevent them from sticking with it through inevitable periods of underperformance.

Chapter-by-Chapter Analysis

Chapters 1-3: Building Blocks

Uses the analogy of Jason selling gum at school to introduce business valuation concepts. Explains how a business's value is determined by its future earnings, introduces the concept of earnings yield, and explains why Mr. Market sometimes offers irrational prices.

Chapters 4-6: The Magic Formula Components

Introduces return on capital (how good the business is) and earnings yield (how cheap the stock is). Explains why these two metrics together identify the best investment opportunities and how they are calculated.

Chapters 7-9: Evidence and Application

Presents backtesting results showing the Magic Formula's significant outperformance over 17+ years. Discusses why the formula works, why it will continue to work, and provides step-by-step implementation instructions.

Chapters 10-13: Why Most People Won't Follow It

Explains the psychological barriers to following the formula, including periods of underperformance, the temptation to cherry-pick, and the difficulty of maintaining discipline. Discusses why professional investors and index funds fail to capture these returns.

Key Concepts & Frameworks

  • The Magic Formula: Ranking stocks by the combination of high earnings yield (cheap price) and high return on capital (good business)
  • Mr. Market: Benjamin Graham's analogy of the market as an emotional business partner who offers to buy or sell at different prices each day
  • Earnings Yield: EBIT/Enterprise Value, measuring how cheap a stock is relative to its earnings power
  • Return on Capital: EBIT/(Net Working Capital + Net Fixed Assets), measuring how efficiently a business uses its capital

Practical Trading Applications

  • Buy the top 20-30 ranked Magic Formula stocks in equal-weighted positions
  • Hold each position for approximately one year, then rebalance
  • Expect periods of underperformance lasting 1-3 years; the formula works over 3-5 year horizons
  • Do not cherry-pick from the formula's selections; buy the entire portfolio mechanically
  • Use the free screening tool at magicformulainvesting.com to identify candidates

Critical Assessment

Strengths: Greenblatt achieves the rare feat of making sophisticated value investing concepts accessible to complete beginners without sacrificing intellectual rigor. The backtesting evidence is compelling, and the practical implementation instructions are clear and actionable.

Weaknesses: The backtesting period may not be fully representative of all market environments. The formula excludes financial and utility stocks, limiting its applicability. The simplicity that makes it accessible may also lead investors to underestimate the difficulty of sticking with it during drawdowns.

Key Quotes

  • "If you really want to 'beat the market,' most professionals and academics can't help you."
  • "Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match."
  • "The secret to making money in stocks is not to get scared out of them."

Conclusion & Recommendation

"The Little Book That Still Beats the Market" is one of the best introductions to value investing ever written. Greenblatt's Magic Formula provides a systematic, easy-to-implement strategy backed by strong empirical evidence. The book's greatest insight may not be the formula itself but the explanation of why most investors will fail to follow it -- offering a profound lesson in behavioral finance. Highly recommended for all levels of investors, from beginners seeking their first strategy to experienced traders wanting to add a systematic value component to their portfolio.