ntroduction: Why the Magic Formula Still Matters
Value investing has always attracted investors searching for simple, repeatable strategies. Joel Greenblatt, a hedge fund manager, professor, and author, offered just that in The Little Book That Beats the Market (2005) and its sequel in 2010. His “Magic Formula” promised a disciplined way to buy good companies at cheap prices — without needing Wall Street-level expertise.
But does it still work today? And how can investors apply it in modern markets? Let’s dive deep into how Joel Greenblatt’s Magic Formula works, its advantages and limitations, and how you can put it into practice.
What Is Joel Greenblatt’s Magic Formula?
At its core, the Magic Formula is a ranking system that identifies undervalued, high-quality companies. Instead of relying on gut instinct or complex fundamental analysis, it uses two simple metrics:
- Earnings Yield = EBIT ÷ Enterprise Value
- Measures how cheap a stock is relative to its operating earnings.
- Return on Capital (ROC) = EBIT ÷ (Net Fixed Assets + Working Capital)
- Measures how efficiently a company generates profit from its assets.
By combining these, investors rank companies, select the top 20–30, and build a portfolio. The logic is straightforward:
- Cheap + Good = Market-beating returns.
How to Apply the Magic Formula: Step-by-Step
- Set Criteria
- Minimum market cap: $50M–$100M (to avoid micro-caps).
- Exclude financials, utilities, and foreign ADRs.
- Calculate Earnings Yield
- EBIT ÷ Enterprise Value (EV = Market Cap + Debt – Cash).
- Calculate Return on Capital (ROC)
- EBIT ÷ (Net Fixed Assets + Working Capital).
- Rank Companies
- Rank by earnings yield (cheapness).
- Rank by ROC (quality).
- Add scores and find the top-ranked firms.
- Build Portfolio
- Buy 2–3 stocks per month until holding 20–30 names.
- Hold losers <1 year (tax-loss harvesting).
- Hold winners >1 year (benefit from long-term capital gains).
- Rebalance Annually
- Repeat the process every year for 5–10+ years.
👉 The formula works because it enforces discipline, prevents emotional decision-making, and tilts toward undervalued businesses with strong fundamentals.
The Origins: Joel Greenblatt and Gotham Capital
Joel Greenblatt is best known for founding Gotham Capital, where he delivered annual returns exceeding 40% between 1985–2006. He later distilled his methods into a book for everyday investors, making professional-grade value investing accessible.
He credits influences like Benjamin Graham (deep value) and Warren Buffett (quality businesses) — blending them into a quantitative, rules-driven approach that anyone can follow.
Does the Magic Formula Still Work?
Originally, Greenblatt reported 30%+ annualized returns from backtests. Independent studies confirm outperformance, though at lower levels in modern markets:
- 2003–2015 backtest: 11.4% vs. S&P 500’s 8.7%.
- 2010–2020 period: Outperformed in value-driven years, underperformed during growth/tech booms.
- Post-2020: Performance mixed; large-cap growth outperformed, but Magic Formula still added value in cyclical and small/mid-cap sectors.
👉 Key lesson: The strategy isn’t “magic.” It works best when markets rotate toward value stocks and when investors stick with it long term.
Advantages of Magic Formula Investing
✅ Simplicity – Requires only two ratios; no advanced financial modeling.
✅ Discipline – Removes emotion from investing decisions.
✅ Accessibility – Can be applied by retail investors with minimal tools.
✅ Tax Efficiency – Built-in structure around tax-loss harvesting and long-term gains.
✅ Backtested Success – Consistent evidence of outperformance over decades.
Disadvantages and Limitations
❌ Not Foolproof – Underperforms in growth-driven markets (e.g., 2010s tech boom).
❌ Excludes Certain Sectors – Banks, insurers, and utilities don’t fit the model.
❌ Requires Patience – Returns accrue over 5–10 years, not months.
❌ Crowding Effect – More investors using the strategy may reduce its edge.
❌ Simplistic Metrics – Doesn’t account for debt levels, moats, or macro risks.
Modern Applications of the Magic Formula
Today, investors have more ways to apply Greenblatt’s strategy:
- DIY Stock Screening
- Use screeners like Stock Rover, Finviz, or Greenblatt’s own tool to rank stocks.
- ETFs and Funds
- Some ETFs mimic Magic Formula screens, giving instant diversification.
- Global Application
- Originally U.S.-focused, but investors now apply it in Europe, India, and emerging markets.
- Caution: accounting standards differ, requiring normalization.
- Enhancements
- Adding debt/equity ratios, free cash flow yield, or dividend filters.
- Combining with momentum screens for hybrid strategies.
Case Example: Applying the Formula in 2025
Let’s say we apply the screen to mid-cap industrials and consumer staples in the U.S. and Europe:
- Top Picks by ROC and Yield: Shipping, food processing, specialty manufacturing.
- Results: High cash flow, undervalued due to cyclical fears.
- Portfolio Approach: Buy 25 of the top-ranked names, rebalance annually.
👉 This shows how the formula still uncovers opportunities in overlooked, boring sectors that may outperform flashy growth stocks.
FAQs: Magic Formula Investing
Q: Is the Magic Formula only for beginners?
No — while simple, professional investors also use it as a baseline screen before deeper analysis.
Q: Can I apply the formula to small-cap stocks?
Yes, but risk increases. Greenblatt excluded small-caps due to volatility and liquidity concerns.
Q: What if the formula picks a “bad” company?
That’s why you buy 20–30 stocks. Diversification smooths out individual losers.
Q: Does it beat the market every year?
No. Like all value strategies, it underperforms in certain cycles. Patience is key.
The Bottom Line
Joel Greenblatt’s Magic Formula remains a powerful introduction to disciplined value investing. While its original 30% returns may not be achievable today, the method still tilts portfolios toward undervalued, high-quality businesses — a combination with proven long-term advantages.
Applied with patience, tax awareness, and global perspective, the Magic Formula is less about “magic” and more about consistent, systematic wealth building.
