Book Review > The Little Book that (Still) Beats the Market

“The Little Book that (Still) Beats the Market” is another title in “The Little Book” series of investment books which consider basic aspects of investment in an easily digestible form for investors.  Joel Greenblatt’s 200 page second edition of his 2005 bestseller looks at what has happened since his original title was published and whether or not his “magic formula” was able to withstand the rigours of the Global Financial Crisis and the resulting gyrations of the stock market. In doing so, he updates and builds on the research he has relied on in establishing his “magic formula”, which aims to help investors beat the market and market professionals by a large margin at very low risk, by buying good businesses at bargain prices. 

The end result is that his method did withstand the financial crisis and continued to show results which outperformed the market and professional managers over various periods (e.g., 1988-2009: Magic Formula used for the Top 1000 companies produced a return of 19.7% p.a. as against the return from S&P500 of 9.5% p.a.) and decile groupings (each decile group outperformed the group immediately below).  It should be noted, too, that the formula can underperform the market at times and can also have negative returns, although these are few.

While some readers may find his language a little breezy or flippant at times, Greenblatt takes nothing for granted, so starts at the beginning and works through a number of clearly explained steps before setting out in the final chapter how to go about utilising his “magic formula”.  He explains the difference between price and value, and how a change in the former won’t affect the latter.  He believes the key to success for investors, apart from consistency and discipline in applying the formula, is to understand why the formula works, and this is what he sets about doing in the early chapters.  The discipline is important so an investor is able to stick with the (successful) strategy over the long term because it may not always be successful during the short term due to the unpredictability of “Mr. Market” and the fact that the market may take a few years to recognise value.

Greenblatt’s formula can be summarised as “buying good companies (ones that have a high return on capital) …... only at bargain prices (at prices that give you a high earnings yield)”.  “For earnings yield, the formula looks for companies that earn a lot compared to the price we have to pay.  For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings”. Companies are ranked according to each criteria and these are then combined – the best combinations win out –, so that a company that ranked high on both criteria would be preferred to one that ranked high on one aspect but medium or low on the other; and another ranking medium in both criteria could rank higher than another with a very high ranking in one criteria but a very low one in the other.  The end result is finding companies that earn a lot relative to the price paid – “buying above-average companies at below-average prices”.  And the beauty of it is that investors can do it themselves.   

The definitions of “return on capital” and “earnings yield” are slightly different to what many investors would use, but these are clearly explained in an appendix.                                                                                                                                                                                                                                     

While the formula has successfully worked for the American market, Greenblatt himself has not tested it for international markets but believes the principles behind it are universal. He states that some Wall Street firms have tested it in overseas markets and found that it worked “in pretty much all foreign markets tested”.

Readers interested in finding out more about Greenblatt’s magic formula can visit his recently established website at www.magicformulainvesting.com, which also offers a service for American investors who wish to have someone do the work for them in choosing which stocks meet the magic formula.

This “Little Book” is a readable and affordable one which will be of interest to investors wishing to broaden their investment knowledge and to those looking for a methodology or filter to experiment with which may help them enhance their investment returns.

Owen Davis is a member of the AIA.