Joel Greenblatt's Magic Formula: buy good and cheap together
A beginner-friendly lesson on Joel Greenblatt's Magic Formula: how to rank businesses by quality and price together, why the method needs a diversified basket and patience, and where the screen can mislead.
Who & why
Most stock screens answer one question: is this cheap, or is this high quality? Joel Greenblatt's lesson is that beginners often need both answers at once.
Greenblatt founded Gotham Capital in 1985, later taught value investing as an adjunct professor at Columbia Business School, and wrote The Little Book That Beats the Market (2005) to explain a simple ranking system he called the Magic Formula. In a 2018 interview, he said he wrote the book for his kids and that the formula has only two parts: cheap and good. 12
The beginner's takeaway is mechanical, not mystical: rank businesses by quality and by price, then study the names that score well on the combination. The "magic" is the discipline of buying out-of-favor companies as a group and waiting long enough for the market to care again.
The core idea
Greenblatt treats a stock as a claim on a business. To judge the price, he looks at how much operating earnings the buyer gets for the enterprise value paid. In interviews he describes this as an earnings yield: earnings before interest and taxes compared with enterprise value (market value plus debt, adjusted for cash). A higher earnings yield means more earnings for each dollar of capital the buyer is putting at risk. 3
To judge the business, he looks at return on tangible capital: how much earnings the company produces from the working capital and fixed assets needed to run it. A store that turns a modest pile of inventory and fixtures into strong earnings scores better than a store that needs a warehouse full of capital to earn almost nothing. 13
The formula does not hunt for the single cheapest name or the single highest-quality name. It ranks a broad universe on each measure, adds the ranks, and keeps the best combined scores. Financial companies and utilities are usually set aside because the same metrics do not fit their balance sheets or regulated economics. Greenblatt's published process also points beginners toward a diversified basket — often described as at least about 20 stocks — rather than one dramatic pick. 34
In plain English: look for above-average businesses available at below-average prices, then own enough of them that no single story has to be perfect.
In their own words
In a 2010 Forbes interview, Greenblatt put the ranking rule in one sentence:
"We're not looking for the cheapest company. We're not looking for the highest return-on-capital company. We're looking for the companies that have the best combinations of those two attributes." 3
He also explained why the method feels uncomfortable while it is working:
"It's very difficult to buy these stocks. They're all out of favor... I can't tell you which ones are going to work out. But I can tell you, the group of stocks that don't work out, you didn't pay very much for them." 3
In Hedge Fund Market Wizards, Greenblatt went further. A strategy that worked every month would be copied until it stopped working. Periods when value underperforms for a year or two, and sometimes longer, are part of the reason the approach can keep working for people who understand it:
"Value investing doesn't always work. The market doesn't always agree with you... And that is a very good thing." 5
The story that proves it
The proof Greenblatt offered beginners was a test, not a single stock tip. Working with partner Rob Goldstein, he ranked large sets of U.S. companies by earnings yield and return on capital, combined the ranks, and checked what a simple portfolio of top names would have done over long stretches of history. In the Masters in Business interview, he said the first test came out so well that he wrote the Little Book around it. 1
In the Market Wizards account, the test used Compustat point-in-time data starting in 1988 so the rankings used information available at the time. Across the long backtest he described, a portfolio of top Magic Formula names selected from large-capitalization stocks roughly doubled the S&P 500's return; smaller-company versions looked even stronger, with more liquidity risk. The rankings also lined up by decile: better combined scores beat worse combined scores in order. 35
That is the part of the story beginners can use. The formula did not identify which one name would shine next year. It forced a process: buy a basket of companies that look good and cheap on crude public numbers, accept that some will disappoint, and give the group years rather than quarters.
Greenblatt's own hedge-fund career is a different case. In the same interview he said Gotham returned about 50% a year before fees over ten years with outside capital, then returned that capital — a result he tied to staying small, staying concentrated, and luck. 1 The Magic Formula is the classroom version of the cheap-and-good idea, not a path to recreate that concentrated track record.
What this means for you
Turn the idea into a judgment filter before any buy or sell decision:
- Score the business and the price separately. Write one note on quality — durable demand, capital needs, competition, and whether recent earnings look normal — and one note on price — how much earnings you get for the enterprise value. A name that wins on only one score is incomplete.
- Write the holding period before you buy. Greenblatt's public process points to roughly annual refresh and multi-year patience. Decide in advance what would make you abandon the method — a broken business thesis, or a bad month of relative performance. Relative underperformance alone is the test most people fail. 45
A beginner who only indexes can still borrow the habit: when a popular stock story sounds irresistible, ask whether you are paying a high price for average economics, or a fair price for unusual economics.
Where it breaks
The formula is easy to describe and hard to live with. Greenblatt has said repeatedly that the method does not win every year, and that many people leave after one or two weak periods. 56
The metrics are also blunt. Earnings can be temporarily inflated or depressed. Return on capital can look wonderful just before competition arrives. Enterprise value can mislead when the balance sheet is complicated. Financials and utilities need different tools. A high combined rank is a lead, not proof that the business is safe.
Historical backtests are educational case studies. They do not tell you what any stock will do next, and they do not turn a past ranking list into advice to buy those names today.
The durable filter is simple: demand both a good business and a cheap price, own the idea as a group rather than a story, and stay long enough for the market to notice. That is Greenblatt without the mythology — and without turning a historical screen into a stock tip.
References
- 1
- 2Get Briefed: Joel Greenblatt - Forbes
forbes.com
- 3Transcript: Joel Greenblatt - Forbes
forbes.com
- 4Magic Formula Investing - How it Works
magicformulainvesting.com
- 5Joel Greenblatt – Value Investing Doesn't Always Work - The Acquirer's Multiple
acquirersmultiple.com
- 6
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