The author has perfected a formula that he has used to beat the market consistently and earn more returns than what the index has provided. He calls it the Magic Formula Investing. The formula is explained in the book in relatively easy language. According to Greenblatt what you need to be concerned is just 2 things about a company:
- A company’s earnings yield
- Return on capital
The rationale is straightforward: buy shares in good businesses, measured by returns on capital, only when they’re available at bargain prices, defined as a high earnings yield.
The magic formula looks for companies that have the best combination of earnings yield and return on capital, with each input weighed equally. An outstanding company with an expensive stock ranked, say, first for return on capital but 1,999th on earnings yield, would have the same combined ranking of 2,000 as a low return on capital company within expensively priced shares, ranking 1,999th in return on capital but first on earnings yield.
Using this approach to create a regularly updated portfolio of about 30 stocks with the highest combined rankings, Mr Greenblatt tested his formula between 1988 and 2004. The results were remarkable: with only one down year, the magic portfolio would have returned 30.8 per cent a year, against a 12.4 percent annual return for the S&P 500. Rather than using the latest 12 months’ earnings to calculate earnings yield and return on capital, Mr Greenblatt and his analysts try to improve on the rote application of this formula by using earnings estimates in a “normal” year, one in which nothing unusual is happening within the company, its industry or the overall economy.
The Little Book That Beats The Market
Author – Joel Greenblatt
Pages – 176
Publisher – Wiley