Key Takeaways
1. The Magic Formula: Buy Good Companies at Bargain Prices
Buying good businesses at bargain prices is the secret to making lots of money.
The Magic Formula explained. This simple yet powerful strategy involves two key components:
- Identifying good businesses: Companies with high returns on capital
- Finding bargain prices: Stocks with high earnings yields
The formula systematically selects companies that rank high in both categories, essentially finding above-average companies at below-average prices. This approach has historically outperformed the market by a significant margin.
Why it works. The magic formula capitalizes on:
- Market inefficiencies
- Short-term thinking of most investors
- Mr. Market's emotional swings
2. Mr. Market: Your Emotional Business Partner
Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices.
Understanding Mr. Market. Benjamin Graham's concept of Mr. Market helps investors understand stock price volatility:
- Mr. Market is your hypothetical business partner who offers to buy or sell shares daily
- His mood swings wildly, sometimes overly optimistic, other times pessimistic
- These mood swings create opportunities for rational investors
Long-term rationality. While Mr. Market is emotional in the short term, he eventually gets it right:
- Over time, stock prices tend to reflect the true value of businesses
- Patience allows investors to benefit from temporary mispricing
- This concept underpins the success of value investing strategies like the Magic Formula
3. Earnings Yield and Return on Capital: The Two Key Metrics
The magic formula ranks companies based on two factors: return on capital and earnings yield.
Earnings Yield (EBIT/EV):
- Measures how much a company earns relative to its price
- EBIT (Earnings Before Interest and Taxes) / Enterprise Value
- Helps identify undervalued companies
Return on Capital (EBIT / (Net Working Capital + Net Fixed Assets)):
- Measures how efficiently a company uses its capital
- Identifies companies with sustainable competitive advantages
- High return on capital often indicates a "good" business
Why these metrics matter:
- They provide a standardized way to compare companies across different industries
- They account for differences in debt levels and tax rates
- They focus on the core profitability and efficiency of businesses
4. Patience is Key: The Formula Works Over Time
Following the formula for any three-year period in a row, the magic formula beat the market averages 95 percent of the time (160 out of 169 three-year periods tested)!
Short-term underperformance is normal. The magic formula doesn't work all the time:
- Underperforms the market in 5 out of 12 months on average
- Can lag behind for 1-2 years at a time
Long-term outperformance is remarkable:
- Beat the market in 95% of 3-year periods
- Never lost money over any 3-year period in the study
- Achieved superior returns with lower risk than the overall market
Why patience matters:
- Allows time for market inefficiencies to correct
- Smooths out short-term volatility
- Gives the strategy time to prove its effectiveness
5. Diversification: Hold 20-30 Stocks for Best Results
Remember, the magic formula works on average, so holding many stocks that are ranked highly by the magic formula should help keep us close to that average over time.
Optimal portfolio size:
- 20-30 stocks provide sufficient diversification
- Balances concentration and risk management
Benefits of diversification:
- Reduces impact of individual stock volatility
- Increases chances of capturing the "average" return of the strategy
- Protects against unforeseen company-specific risks
Implementation tips:
- Build the portfolio gradually over 9-12 months
- Replace 5-7 stocks every few months as they reach their one-year holding period
- Maintain discipline in following the formula's recommendations
6. The Tooth Fairy Doesn't Exist on Wall Street
On Wall Street, there ain't no tooth fairy!
Harsh realities of investing:
- No one will magically make money appear under your pillow
- Most professional advice and services underperform the market
- You are ultimately responsible for your investment decisions
Common pitfalls to avoid:
- Relying on stockbrokers who are incentivized to sell, not make you money
- Chasing past performance of mutual funds
- Paying high fees for underperforming actively managed funds
Alternatives to consider:
- Index funds for passive, low-cost market exposure
- The Magic Formula for a systematic, evidence-based approach
- Self-directed investing if you have the time, knowledge, and discipline
7. Long-Term Thinking: Stick to the Strategy for 3-5 Years Minimum
Remember, you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work!
The importance of commitment:
- Short-term underperformance is normal and expected
- Long-term results are what matter
- Emotional discipline is crucial for success
Why people fail:
- Lack of patience during periods of underperformance
- Tendency to chase recent winners or popular stocks
- Inability to stick with a strategy that seems to be "not working"
Building conviction:
- Understand the logic behind the Magic Formula
- Study historical results and long-term performance
- Prepare mentally for periods of difficulty
8. Compound Interest: The Eighth Wonder of the World
By contributing just $28,000 in total over the next six years [...] your retirement account could have grown to over $325,000 at the end of 20 years and over $1.3 million after 30 years.
The power of compounding:
- Small, consistent investments can grow dramatically over time
- Higher returns amplify the effect of compounding
- Time is a crucial factor in building wealth
Practical implications:
- Start investing early, even with small amounts
- Maximize contributions to tax-advantaged accounts like IRAs
- Reinvest dividends and capital gains to accelerate growth
Long-term perspective:
- Focus on decades, not months or years
- Understand the exponential nature of compound growth
- Make decisions based on long-term financial goals
9. Give Back: Use Your Success to Make a Difference
I also hope that those investment goals will include using some of your good fortune to make a difference in those areas that are important and have meaning to you.
The importance of giving:
- Financial success creates opportunities to help others
- Giving can provide personal fulfillment and purpose
- Addressing societal issues can have a lasting impact
Potential areas for impact:
- Education reform
- Medical research
- Poverty alleviation
- Social justice initiatives
Thoughtful giving:
- Apply investment principles to charitable efforts
- Look for high "return on capital" in social initiatives
- Consider long-term, systemic changes rather than short-term fixes
Last updated:
FAQ
What's "The Little Book That Beats the Market" about?
- Overview: "The Little Book That Beats the Market" by Joel Greenblatt introduces a simple, systematic approach to investing in the stock market using a "magic formula."
- Magic Formula: The book presents a formula that combines high earnings yield and high return on capital to identify undervalued stocks.
- Target Audience: It is written for both beginners and experienced investors, aiming to simplify the process of finding good investment opportunities.
- Educational Purpose: Greenblatt's goal is to teach readers how to make money in the stock market in a way that is easy to understand and apply.
Why should I read "The Little Book That Beats the Market"?
- Simple Strategy: The book offers a straightforward investment strategy that has historically outperformed the market.
- Educational Value: It provides insights into how the stock market works and how to evaluate companies, making it a valuable resource for learning about investing.
- Proven Results: The magic formula has been tested over 17 years, showing significant returns compared to the market average.
- Practical Application: The book includes step-by-step instructions for implementing the strategy, making it accessible for readers to apply in real life.
What is the "magic formula" in "The Little Book That Beats the Market"?
- Two Key Metrics: The magic formula focuses on two main metrics: high earnings yield and high return on capital.
- Earnings Yield: This measures how much a company earns relative to its price, indicating if a stock is undervalued.
- Return on Capital: This assesses how efficiently a company uses its capital to generate profits, identifying good businesses.
- Combination Strategy: By combining these metrics, the formula aims to find good companies available at bargain prices.
How does Joel Greenblatt's "magic formula" work?
- Ranking System: The formula ranks companies based on their earnings yield and return on capital, selecting those with the best combination.
- Portfolio Construction: Investors are advised to build a portfolio of 20-30 stocks that rank highly according to the formula.
- Long-term Focus: The strategy requires patience, as it may take several years for the market to recognize the value of these stocks.
- Historical Performance: Over a 17-year period, the formula has shown to significantly outperform the market averages.
What are the key takeaways of "The Little Book That Beats the Market"?
- Invest in Good Companies: Focus on companies with high returns on capital, as they are likely to have competitive advantages.
- Buy at Bargain Prices: Look for stocks with high earnings yields to ensure you are buying undervalued companies.
- Patience is Crucial: The strategy may not work in the short term, but it has proven successful over longer periods.
- Simplicity Works: A simple, systematic approach can outperform more complex investment strategies.
What are the best quotes from "The Little Book That Beats the Market" and what do they mean?
- "Buying good businesses at bargain prices is the secret to making lots of money." This encapsulates the book's core strategy of combining quality and value in stock selection.
- "The magic formula works because it makes perfect sense." Greenblatt emphasizes the logical foundation of the formula, which is based on sound financial principles.
- "Over the long run, Mr. Market gets it right." This quote highlights the importance of a long-term perspective, as market prices eventually reflect true company value.
- "You must believe that the magic formula will work and maintain a long-term investment horizon." This stresses the need for conviction and patience in following the strategy.
How does "The Little Book That Beats the Market" address risk?
- Long-term Perspective: The book suggests that risk is minimized by maintaining a long-term investment horizon, allowing time for the market to recognize value.
- Diversification: By holding a portfolio of 20-30 stocks, investors can reduce the impact of any single stock's poor performance.
- Focus on Fundamentals: The formula's reliance on earnings yield and return on capital helps identify fundamentally strong companies, reducing the risk of investing in poor businesses.
- Historical Evidence: The book provides historical data showing that the formula has consistently outperformed the market with lower risk over time.
What is the role of "Mr. Market" in "The Little Book That Beats the Market"?
- Market Volatility: "Mr. Market" represents the stock market's emotional and irrational behavior, leading to price fluctuations that do not always reflect true value.
- Investment Opportunities: These fluctuations create opportunities to buy good companies at bargain prices when Mr. Market is overly pessimistic.
- Long-term Rationality: Over time, Mr. Market tends to correct these mispricings, allowing patient investors to profit from their investments.
- Concept Origin: The idea of Mr. Market is borrowed from Benjamin Graham, emphasizing the importance of a disciplined investment approach.
How does "The Little Book That Beats the Market" compare to other investment strategies?
- Simplicity vs. Complexity: The magic formula is simpler than many other strategies, focusing on just two key metrics rather than complex analyses.
- Proven Track Record: Unlike some strategies that rely on predictions or market timing, the magic formula has a documented history of success.
- Accessibility: The book is designed for a broad audience, making it easier for individual investors to implement compared to more sophisticated strategies.
- Focus on Value: The formula aligns with value investing principles, which have been shown to outperform growth strategies over the long term.
What are the limitations of the "magic formula" in "The Little Book That Beats the Market"?
- Short-term Underperformance: The formula may not outperform the market in the short term, requiring patience from investors.
- Market Conditions: In certain market environments, such as during bubbles or crashes, the formula's effectiveness may be challenged.
- Data Dependence: The formula relies on accurate financial data, and any discrepancies can affect stock selection.
- Behavioral Challenges: Investors may struggle to stick with the formula during periods of underperformance, despite its long-term success.
How can I implement the "magic formula" from "The Little Book That Beats the Market"?
- Use Online Tools: Websites like magicformulainvesting.com can help identify stocks that meet the formula's criteria.
- Build a Portfolio: Gradually construct a portfolio of 20-30 stocks, adding new stocks every few months to diversify.
- Follow Holding Guidelines: Hold each stock for about one year, adjusting for tax considerations by selling winners after one year and losers before.
- Commit to the Process: Stay disciplined and committed to the strategy for at least three to five years to allow the formula to work.
What is the educational value of "The Little Book That Beats the Market"?
- Investment Basics: The book provides a foundational understanding of key investment concepts like earnings yield and return on capital.
- Market Psychology: It introduces readers to the concept of Mr. Market, helping them understand market behavior and volatility.
- Practical Application: The step-by-step instructions make it easy for readers to apply the magic formula in real-world investing.
- Long-term Thinking: The book emphasizes the importance of patience and a long-term perspective in achieving investment success.
Review Summary
The Little Book That Beats the Market receives mixed reviews, with an average rating of 3.97/5. Many readers appreciate its simple, accessible approach to investing, finding it useful for beginners. The book's "magic formula" for stock selection is praised by some for its potential effectiveness, while others criticize it as overly simplistic. Some readers find the writing style engaging and humorous, while others consider it repetitive or condescending. Overall, the book is seen as a good introduction to value investing, though opinions vary on its applicability for experienced investors.
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About the Author
Other books by Joel Greenblatt
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