This 2010 release is an update of Greenblatt’s original The Little Book That Beats the Market, a New York Times Bestseller. In his book, Greenblatt, a Wharton School graduate and highly successful hedge fund manager, presents a clear and simple investment strategy that any investor can follow. He humorously presents his “Magic Formula” in all its glory in under 150 simple to read pages.
Greenblatt is a value investor, and he mentions Benjamin Graham, the father of value investing, a number of times in this book. Graham had something of a “Magic Formula” himself, but as Greenblatt points out, Graham’s formula does not work very well in the our time as it would be rare for any current stock to meet Graham’s strict criteria. Greenblatt’s “Magic Formula” uses two measures of stock value to create a list of stock candidates from the top quintile of all stocks, so there are always candidates to choose from.
Greenblatt argues that while there are better methods for valuing stocks that he and other professionals use, anyone can capture the vast majority of the profits while exerting a minimal amount of the energy by using the “Magic Formula.” Stock prices should be based on the future earnings power of the stock; but predicting the future is not only extraordinarily hard to do, it is fraught with many pitfalls and wrong turns. The vast majority of investors, Greenblatt argues, would be better off following his simple formula.
The “Magic Formula” is based on two stock indicators: Return on Capital and Earnings Yield. Return on Capital is Greenblatt’s preferred measurement of how good (profitable) a company is, and Earnings Yield shows if the stock is available at a good price. The “Magic Formula” balances these two values to produce a list of the best stocks to buy. A stock, no matter how cheap based on Earnings Yield would not make the list if it is a bad business based on Return on Capital. Greenblatt also provides a website which will show you a list of stocks so you don’t even have to do any of the leg work yourself.
The formula calls for you to maintain 20 – 30 holdings, and sell each holding after one year. The number of holdings will help minimize the damage to your return one or two bad apples can cause. The one year holding period recommendation is so you do not hold a stock for too short or too long to take advantage of the gains. Greenblatt points out that you must stick to the formula through thick and thin. While the formula has given tremendous return compared to a stock index, there are periods in which the “Magic Formula” under-preforms the market.
The book does present a reasonable approach to investing for those not willing or not able to dedicate a lot of time to their investments. Greenblatt acknowledges that index funds are a good way to go for most investors for the same reason other authors and market gurus have already presented: most mutual funds do not beat the index funds, and most investors do not have the knowledge, time and resources to invest like real professionals. Enter the “Magic Formula” which, over a seventeen year track record, has beaten the index funds.
The author does acknowledge that his formula is not perfect, but he feels that it is good enough to beat the market. He also offers a little advise on tweaking the formula for investors willing to spend more time with their investments, but he warns that doing so can be risky.
If you buy into the argument that index funds are a superior way for most people to invest their money, then you may want to consider Greenblatt’s “Magic Formula” as another investment alternative. Personally, I would prefer if Greenblatt had done a better job of showing and explaining data to back up his claims. Unfortunately, Greenblatt’s argument seems to be “Just trust me.” Despite the fact I see this as a shortcoming of the book, I do trust in the “Magic Formula.”