The Magic Formula 🎩
Greenblatt's magic formula comes down to two things:
1. Buy good companies (high return on capital) 2. Buy them cheap (high earnings yield)
That's it. That's the whole strategy.
He ranks companies by these two factors, combines the rankings, and invests in the top-ranked stocks. Hold them for a year. Rinse and repeat.
No fancy analysis. No predicting the future. No watching CNBC. Just find companies that are both good and cheap, buy them, and wait.
Breaking Down "Good" 📊
What makes a company "good" in Greenblatt's system? Return on capital.
This measures how much profit a company generates relative to the capital invested in the business. It's basically asking: for every dollar this company has tied up in its operations, how much profit does it generate?
A company earning $20 million on $100 million of capital has a 20% return on capital. That's good—better than most investments.
A company earning $5 million on $100 million of capital has a 5% return. That's mediocre—you could get that from a savings account.
Why does this matter? Companies with high returns on capital have something special. Maybe a strong brand. Maybe network effects. Maybe proprietary technology. Something that lets them earn above-average profits.
These are the companies Warren Buffett talks about having "moats"—competitive advantages that protect their profits.
Greenblatt wants these companies because they're likely to keep earning high returns, compounding your wealth over time.
Breaking Down "Cheap" 💰
What makes a company "cheap"? Earnings yield.
This is just the inverse of the P/E ratio. If a company has a P/E of 10, its earnings yield is 10% (1/10). If the P/E is 20, the earnings yield is 5%.
Earnings yield tells you: for every dollar I pay for this stock, how much in earnings am I getting?
A 10% earnings yield means you're paying $10 for $1 of earnings. That's better than a 5% earnings yield, where you're paying $20 for $1 of earnings.
Greenblatt wants high earnings yields because you're getting more earnings per dollar invested. You're paying less for the same profit stream.
This is classic value investing—buying dollars for fifty cents.
Why Combine Them? 🤝
Here's where it gets clever. Most investors focus on one or the other.
Value investors buy cheap companies—but sometimes they're cheap for a reason. The business sucks. Profits are declining. They're "value traps" that just keep getting cheaper.
Growth or quality investors buy good companies—but often overpay. Yes, it's a great business, but if you pay too much, your returns will be mediocre.
Greenblatt says: why not buy companies that are both good AND cheap?
Good companies that are temporarily cheap—maybe because of short-term bad news, maybe because they're in an out-of-favor sector, maybe just because Mr. Market is having a mood swing.
These companies have the quality to compound wealth long-term, but you're buying them at prices that give you a margin of safety.
The Backtests 📈
Greenblatt tested this formula going back decades. His findings:
The magic formula returned about 30% annually from 1988 to 2004, compared to about 12% for the market.
Even in more recent periods with more investors knowing about it, it still significantly beat the market.
Buying the top 30 stocks by the formula and holding for a year, then repeating, consistently outperformed.
Now, 30% annually sounds incredible—and it is. More recent real-world performance has been more modest (but still good). The formula works, but the edges have compressed as more people use it.
Still, even a few percentage points of outperformance compounds dramatically over decades.
Why Does It Work? 🤔
If it's so simple, why doesn't everyone do it?
Greenblatt's answer: because it's psychologically hard.
First, the formula will tell you to buy companies you've never heard of, in boring industries, that nobody's talking about. It takes courage to buy stocks that feel random rather than following a compelling story.
Second, the formula will underperform sometimes—sometimes for a year or more. During those periods, you'll feel stupid. Your friends who own the hot tech stocks will be making money while you own some manufacturing company in Ohio.
Most people can't handle this psychological discomfort. They abandon the strategy right before it starts working again.
Third, you have to actually execute it mechanically. No second-guessing. No "this company looks bad, I'll skip it." The minute you start making exceptions, you've destroyed the system.
The Psychology Problem 🧠
This is really the heart of the book. Greenblatt spends more time on psychology than on the formula itself.
He explains that humans are wired to:
- Extrapolate recent trends (what went up will keep going up)
- Tell ourselves stories (we need a narrative, not just numbers)
- Follow the herd (safety in numbers)
- Avoid looking foolish (better to fail conventionally)
- Abandon strategies that underperform temporarily
All of these tendencies work against the magic formula.
The formula requires you to:
- Ignore recent performance
- Buy based on numbers, not narratives
- Go against the crowd
- Look potentially foolish
- Stick with it through underperformance
This is why simple doesn't mean easy. The formula itself is brain-dead simple. Following it is psychologically brutal.
The Real-World Challenges 💼
When Greenblatt launched a fund based on the magic formula, something interesting happened: the returns were good, but investors still pulled their money out.
Why? Because they couldn't handle the volatility and the periods of underperformance.
The fund would be down when the market was up. Investors would get nervous, sell out, and then the strategy would snap back and outperform—but those investors had already left.
This is the "behavior gap"—the difference between what an investment returns and what investors actually earn, because they buy high (when it's been performing well) and sell low (when it's been underperforming).
Greenblatt realized that having a great strategy isn't enough. Investors need the discipline to stick with it.
How to Actually Use It 🎯
Greenblatt provides specific instructions:
- Go to his website (magicformulainvesting.com) where the formula is calculated for you
- Pick the top 20-30 stocks from the list
- Buy them in equal dollar amounts
- Hold for one year
- Sell and repeat
He recommends buying a few stocks per month over the year rather than all at once, to smooth out timing luck.
He also gives tax tips—sell losers just before the one-year mark (to harvest tax losses) and winners just after the one-year mark (to get long-term capital gains treatment).
It's remarkably straightforward. No complicated analysis required. No reading annual reports. Just follow the formula.
The Limitations ⚠️
Greenblatt is honest about limitations:
Small accounts: If you only have $10,000, buying 30 stocks means $300 positions. After trading costs, this gets inefficient. He suggests either buying fewer stocks or just buying an index fund until you have more capital.
Large accounts: If you have millions, you might not be able to buy enough of small-cap stocks without moving the market. The formula works best for mid-sized accounts.
Market cap: The formula works best on smaller companies that are less analyzed. Large-caps that everyone follows have fewer mispricings.
International stocks: Accounting differences make the formula harder to apply globally, though not impossible.
Concentration risk: You might end up with several stocks in the same beaten-down sector. This can hurt if that sector stays out of favor.
The Index Fund Alternative 🏦
Interestingly, Greenblatt doesn't say everyone should use the magic formula.
If you can't handle the psychology—if you'll panic during underperformance, if you'll second-guess and tinker—you're better off in a low-cost index fund.
A mediocre strategy you stick with beats a great strategy you abandon.
Index funds offer:
- Guaranteed average returns
- No emotional decision-making
- No need for discipline beyond staying invested
- Tax efficiency
- Minimal effort
For most people, this is the right answer.
The magic formula is for people who can handle the psychological challenge and are willing to look foolish sometimes to earn higher returns.
The Story Framework 📖
One of the book's clever devices is explaining everything through a story about running a business with Jason (his fictional partner).
He uses these stories to explain concepts like return on capital, earnings yield, and why certain companies trade cheap.
This makes the book incredibly accessible—you don't need a finance background to understand it. A smart middle schooler could grasp the concepts.
This accessibility is both the book's strength and why some professional investors dismiss it. It seems too simple to work.
But simple and wrong are different things. The formula is simple because it focuses on what matters and ignores what doesn't.
What About Value Traps? 🪤
Critics of the formula ask: what about value traps? Companies that are cheap because they're dying?
Greenblatt's answer: the "good company" filter (high return on capital) screens most of these out. Dying companies usually have low returns on capital.
Could some slip through? Sure. That's why you buy 20-30 stocks, not just one. Diversification handles the individual blow-ups.
Over a portfolio of value stocks with quality characteristics, the winners outweigh the losers.
The Behavioral Advantage 🎭
The formula's real edge might be behavioral, not analytical.
It forces you to:
- Buy when things look scary (stocks are cheap for a reason—usually fear)
- Sell winners (taking profits on stocks that have run up)
- Buy unpopular stocks (nobody's excited about them)
- Ignore stories and narratives (just follow the numbers)
All of these go against human nature, which is exactly why they work.
The market is driven by emotion—fear and greed. The formula is emotionless. It's buying fear and selling greed.
Has It Stopped Working? 📉
As more people learned about the magic formula, the natural question is: has it been arbitraged away?
The answer seems to be: partly, but not entirely.
The returns aren't as extreme as the early backtests. But the strategy still seems to outperform, especially in small and mid-cap stocks.
Why hasn't it been fully arbitraged? Back to psychology. Most investors still can't stick with it through the inevitable periods of underperformance.
Also, the formula sometimes picks weird, uncomfortable stocks. Institutional investors often can't or won't buy them due to mandates or career risk.
The Teaching Tool 🎓
Beyond being an investment strategy, the book is a teaching tool about:
What makes a good business: High returns on capital matter. Profitability matters. Not all revenue is equal.
What value means: It's not just buying anything that's down. It's buying quality at discount prices.
Why markets misprice stocks: Emotion, short-term thinking, and narrative obsession create opportunities.
The importance of discipline: Having a system and sticking to it beats being smart and erratic.
These lessons apply even if you never use the magic formula itself.
The Meta-Lesson 🎯
The book's deeper message: investing doesn't have to be complicated to work.
Wall Street has an incentive to make everything seem complex and mysterious. It justifies fees, creates information asymmetry, and makes you feel like you need experts.
Greenblatt is saying: you don't. The core principles of good investing are simple. Buy good businesses cheap. Be patient. Don't panic.
The formula is just a mechanical way to implement these timeless principles without emotion or judgment screwing things up.
Should You Actually Use It? 🤷
Honest answer: it depends.
Use it if:
- You have a decent-sized account ($50K+)
- You can handle looking wrong for extended periods
- You're disciplined enough to follow it mechanically
- You're okay with boring, unglamorous stocks
- You understand it will underperform sometimes
Don't use it if:
- You'll tinker and second-guess
- You can't stomach volatility
- You need to understand every company's story
- You'll abandon it after a bad year
- You're better suited to passive index investing
There's no shame in choosing the index fund. For most people, it's the right choice.
The Enduring Wisdom ✨
Even if you never run a magic formula screen, the book teaches valuable lessons:
Quality matters. Profitability matters. Price matters. Both together matter most.
Simple, consistent strategies beat complex, erratic ones.
Behavioral discipline is more important than analytical brilliance.
The market will hand you opportunities if you're patient and unemotional.
These truths don't expire. They're as valid now as they were when Benjamin Graham wrote about them 80 years ago, and as they'll be 80 years from now.
Because they're not about predicting the future or finding loopholes. They're about understanding value and having the discipline to act on it.
And that never goes out of style.
The formula is simple. Following it is hard. That's not a bug—it's why it works. 📊