The Magic Formula for Investing in the Stock Market (Book Review: The Little Book That Beats the Market by Joel Greenblatt)

One should always be suspicious of words like ‘secret’, ‘shortcut’, ‘formula’ etc. when it comes to investing, or most other things in life for that matter. Generally, there are no shortcuts in life. In the end, you must log-out of the Netflix and do the tedious jobs of working-out, eating broccoli and analysing a business in detail.

Basically, almost all successful long-term equity investing is about (1) estimating future earnings of a business and (2) buying them at a price lower than the ‘value’ corresponding to those future earnings. This is a tough thing to do, no matter what ‘formula’ you have. Earlier I had written a piece on why most individual investors cannot beat the market-returns and it does not make sense for them to pick individual stocks. Forget about part-timers; majority of professional investors fail to beat the index-returns after accounting for their fees and transaction costs. Hence, it makes sense for most investors to buy the index and end up being an above average investor (above 80 percentiler, I guess), while enjoying the activities they love doing rather than picking stocks.

Having said that, when someone with a reputation and track-record of Joel Greenblatt recommends a Magic Formula to beat the market-returns over the long-term, one has to pay attention. For those who have not heard his name, Joel Greenblatt is considered one of the greatest value-investors of all time along with Ben Graham and Warren Buffett. In his book ‘The Little Book That Beats the Market’, he describes a simple strategy and calls it the Magic Formula, sticking to which for a long-term, a non-professional investor can beat the market-returns with minimum analysis. In fact the formula is not meant for selecting individual stocks but a group of a significant number of stocks based on the formula to work appropriately.

The book explains that if you prepare a portfolio of 20-30 stocks that have (1) high Return on Capital Employed (RoCE) in the past and (2) have high Earnings Yield, and update such portfolio every year, you will beat the market over the long term, i.e., at least more than 3-5 years. Mr. Greenblatt has extensively tested the formula for 17 years. The book elaborates exactly why the formula works so well.

A high RoCE indicates that the business is highly profitable, at least presently. And a high Earnings Yield implies that the stock is available at a price cheaper corresponding to the profit it has earned. There is much more to fundamental stock analysis than the latest RoCE and Earnings Yield, but, as Mr. Greenblatt explains, if a large number of such stocks are bunched in a portfolio, such portfolio will, on average, represent a group of businesses of higher quality available at cheaper valuation.

A step-by-step procedure for building and maintaining such a portfolio is mentioned in the book. The investor would require a stock-screener for following these steps. Such screeners mentioned in the book are for stocks listed in the USA. One such free website available for Indian investors is screener.in, while there are a few others with subscription charges.

The book is written in a simple, jargon-free language and is understandable even to the reader with no background in finance. The author’s sense of humour makes the book more readable. Further, the book is short in length and can be read within a day or two.

The Magic Formula suggested in the book is so simple that the reader would definitely doubt whether it would work in the real world. If something is so simple and effective, it would be used by a lot many people, and that itself should reduce its effectiveness. However, Mr. Greenblatt explains why majority of the investors cannot stick to the formula, and therefore, it will remain effective for those who can continue to invest according to the Magic Formula for a long-term. For someone to stick to the Magic Formula, especially in the stretches when it doesn’t work, he must understand thoroughly why the formula works in the long run and develop a conviction in its ability to beat the market ultimately. The author does a fine job in making the reader understand why the formula works so well.

From the reasoning described in the book as well as the credibility of the author himself on account of his exceptional investment track-record, it seems convincing that the strategy should work. However, the only way to know whether it will work or not is by putting it to use for a long term.

Alternatively, the investor can simply take the learning from the book that high RoCE and Earnings Yield are the two most important factors while analysing a stock, and give high importance to these two factors while selecting individual stocks for investment. However, if this is the alternative you choose, you must keep in mind that beating the market by selecting individual stocks is an extremely difficult task.