The Little Book that Beats the Market

John Wiley & Sons 2005

by Joel Greenblatt
176 pages

Focus
Leadership & Mgt.

Take-Aways
Investing in the stock market makes sense.

Strategy
Sales & Marketing
Corporate Finance
Human Resources
Technology & Production

The hard part of investing in stocks is having discipline and perseverance.

Most people should not attempt to invest in individual stocks.
The best way to invest in stocks is to buy good companies at bargain prices.

Small Business
Economics & Politics
Industries & Regions
Career Development
Personal Finance
Concepts & Trends

For investors, good companies are the ones with a high return on capital.
Good companies with lower P/E ratios than most companies are bargains.
Buy good stocks at bargain prices, hold them a year, then sell them and do the
same process over again.
Investors who follow this magic formula may beat the market by a good margin.
However, investors need patience and discipline because sometimes the magic
formula underperforms the broad market for months or even for years.
Make friends with Mr. Market, but watch out: he's pretty moody.

Rating

(10 is best)

Overall

Applicability

Innovation

Style

To purchase abstracts, personal subscriptions or corporate solutions, visit our Web site at www.getAbstract.com
or call us at our U.S. ofce (954-359-4070) or Switzerland ofce (+41-41-367-5151). getAbstract is an Internet-based knowledge rating service and publisher of book abstracts.
getAbstract maintains complete editorial responsibility for all parts of this abstract. The respective copyrights of authors and publishers are acknowledged. All rights reserved. No part of
this abstract may be reproduced or transmitted in any form or by any means, electronic, photocopying, or otherwise, without prior written permission of getAbstract Ltd (Switzerland).

This summary is restricted to the personal use of Rahul Muralidharan (rahul.muralidharan@in.prtm.pwc.com)

LoginContext[cu=2620045,asp=182,subs=0,free=0,lo=en] 2016-09-12 08:38:35 CEST

Relevance
What You Will Learn
In this Abstract, you will learn: 1) How to use a simple, logical and reportedly effective
method for investing in the stock market; 2) Why this is called the magic formula;
3) How some stock market investing fundamentals work; and 4) Why you should meet
both Benjamin Graham and Mr. Market.
Recommendation
Whether or not this books magic formula delivers the results that author Joel Greenblatt
promises, the book itself presents a lucid, simple explanation of investing in the stock
market. Unlike many who write about investing in stocks and offer formulas for success,
Greenblatt is remarkably honest in his discussion of the difculty of beating the market
and remarkably modest in his claims (although perhaps not quite as restrained in referring
to his Web site). getAbstract nds that the chief merit of this bestseller is not its formula
for success (which derives from guru Benjamin Grahams value approach), but rather its
clear, step-by-step introduction to the fundamentals of investing for novices. The author
makes the market understandable to a child. That is quite an achievement.

Abstract

In fact, the story

even concludes
with a magic
formula that can
make you rich
over time. I
kid you not.

Chewing Gum Lesson

Jason, who is in the sixth grade, has a very effective business model. He buys several
packages of chewing gum for 25 cents each. A pack has ve sticks of gum. Jason sells
each stick of gum at school for 25 cents, making a $1 prot on each pack. With six years
left before he nishes high school, Jason can expect to earn $3,000 in prots before
graduation day. But if you wanted to invest in Jasons company, how would you value it?
That is not such a straightforward matter, although thinking about the value of Jasons gum
empire is a way to understand how the stock market works and how a sound investment
plan should function. What would you pay for half of Jasons enterprise? Not $1,500,
surely, because that price would merely return your money to you. But why would Jason
accept less, since he would stand to earn that much from half of his business?
No simple, universally correct answer exists to the question of what Jasons chewing gum
business is worth. Notions of its value depend on the circumstances of the person doing
the valuation. Thinking through various possibilities, though, offers a way to understand
the stock market a little better. Anyone who buys a stock is buying a share in a business
hence the expression share is used as shorthand for an investment in a business.

Buying good
businesses at
bargain prices
is the secret
to making lots
of money.

Why would you buy shares of stock? The simple answer is to make money. And its not a
bad answer. Investors buy stocks because they hope to make a prot. That is, in fact, the
reason why people usually invest in any type of security. Investors only have four things
they can do easily with their money:
1. Keep it in cash Also known as putting the money in the mattress. Although cash
does not go up or down in nominal value, it does not earn any return. Put $10 in
the mattress, leave it for 10 years, and it will still be $10. However, $10 in 10 years
will probably not buy as much as $10 today, because ination erodes the purchasing
The Little Book that Beats the Market

Copyright 2006 getAbstract

2 of 5

This summary is restricted to the personal use of Rahul Muralidharan (rahul.muralidharan@in.prtm.pwc.com)

LoginContext[cu=2620045,asp=182,subs=0,free=0,lo=en] 2016-09-12 08:38:35 CEST

It takes a great
amount of
discipline to save
any money.

You can stick

your money under
the mattress. (But
that plan kind of
stinks.)

In effect, the
stock market acts
very much like a
crazy guy named
Mr. Market.

power of cash over time. Thus, while the nominal value of cash does not change, its
real value may indeed go down.
2. Put the money in a U.S. government-insured bank account Or buy U.S. government
bonds. The U.S. government is sound, and will pay its debts, so the investor in U.S.
government bonds or guaranteed instruments earns a stipulated rate of interest and
takes no credit risk. The investor does, however, have ination risk. If the ination
rate rises, the investor who bought bonds may actually lose purchasing power.
3. Buy non-U.S. government bonds This includes such things as corporate bonds or
the bonds issued by emerging market countries. Such bonds usually pay a higher
interest rate, but only to compensate for their additional risk.
4. Invest in the stock market.

Investing in the Stock Market

Investors who want to earn more over time than they can expect to get from bonds have
to invest in growth. The easiest way to do that is to buy a share of a growing business.
Buying a share of a business means to purchase a piece, portion or interest in it. Each
investor owns a proportional share of the earnings of the business.
Thus, to decide what the stock is worth, you need to arrive at some forecast or estimate
(pure guesswork in many cases) of the businesss future earnings. However, the future
earnings forecast is not the only element to consider in pricing the stock. Remember
that you can earn risk-free returns from U.S. government bonds. If you cannot earn
sufciently more than the risk-free rate, it does not make sense to invest in the stock.
Whether you think that the return is high enough or not depends on your preferences about
risk, but no rational investor takes risk unless the return justies it. That is, investors
demand to be paid to take risk.

Value versus Price

Stock market prices vary so wildly that they seem to have no relationship to value. Even a
company as big as IBM or General Motors might sell its shares for $30 each one day and
$60 each a few weeks later. Why? Does IBM suddenly sell twice as many computers?
Does GM suddenly sell twice as many cars? Clearly not. Yet over a period of time, any
stock can undergo wild price swings. Prices are much more volatile than fundamental
value. The business may change little, even though share prices change a lot. The stock
price obviously is based on more than the value of the business.
A lot of academic work has gone into attempting to explain why such price swings make
rational sense. That effort seems quixotic. In fact, a satisfactory rational explanation of
stock price moves seems unachievable, although one shorthand explanation is simply
that people just go nuts a lot. Fortunately, investors do not need to understand why
some people buy and sell at wildly different prices over very short periods of time
apparently unrelated to value. You just have to know that they do!

Although over
the short term Mr.
Market may price
stocks based on
emotion, over
the long term Mr.
Market prices
stocks based on
their value.

Stock market guru Benjamin Graham imagined that stock market forces had a personality
and referred to them as Mr. Market. He described Mr. Market as a moody, inconstant
individual who buys and sells shares in businesses. One day, due to his uctuating
moods, Mr. Market might offer to buy or sell at a very low price. On those days, the
rational investor would probably take advantage of Mr. Market by buying from him at
a low price. On other days, Mr. Market would buy or sell at a very high price. On such
days, the rational investor would sell back to Mr. Market what he had bought from him
and pocket a prot. The relevant question for the investor is not why Mr. Market suffers
The Little Book that Beats the Market

Copyright 2006 getAbstract

3 of 5

This summary is restricted to the personal use of Rahul Muralidharan (rahul.muralidharan@in.prtm.pwc.com)

LoginContext[cu=2620045,asp=182,subs=0,free=0,lo=en] 2016-09-12 08:38:35 CEST

We have
designed a new
magic formula
a formula that
seeks to nd good
companies at
bargain prices.

If you just stick

to buying good
companies
(ones that have
a high return
on capital) and
to buying those
companies only
at bargain prices
(at prices that
give you a highearnings yield),
you can achieve
investment returns
that beat the
pants off even the
best investment
professionals.

such unpredictable, erratic mood swings, but rather whether to buy or sell from him on
any given day. His moods offer opportunities to investors who exercise more discipline
and patience than he does.

The Magic Formula

Before deciding whether to buy or sell, ideally the investor should assess the future
earnings potential of the business. Unfortunately, it is extremely difcult to predict the
future of anything, especially a business. Fortunately, you can arrive at a reasonably good
sense of the quality of a business without knowing the future. Consider the companys
return on capital. This means taking the prots or earnings and dividing them by the
capital invested in the business. The beauty of return on capital is that it lets investors
compare two unrelated businesses. A doughnut company and a steel company both
require capital. Even though doughnuts and steel have nothing else in common, they
both have return on their capital. Generally speaking, investors do better in businesses
whose return on capital is high, not low.
How the Formula Works
Paying a bargain price for a business is good for investors. But you also want to buy good
businesses dened as businesses that earn a high return on invested capital. Buying
a good business at a bargain price is the magic formula for winning in the market, if
you add patience.
Graham, perhaps the greatest stock market thinker of the twentieth century, created
this magic formula. His idea of a bargain was remarkable it called for purchasing
stocks at prices so low that closing the business and selling all of its assets would make
a prot for the investor.
However, Graham came up with his formula during the desperate years of the Great
Depression. When the economy recovered, few businesses were selling for prices
lower than their liquidation value. Today, nding stocks that meet Grahams strict
criteria is rarely, if ever, possible. Fortunately, investors can still earn solid, substantial
returns by buying stocks, even though they must pay higher prices than Graham would
countenance.

The magic
formula works for
companies both
large and small.

For the magic

formula to work
for you, you must
believe that it
will work and
maintain a longterm investment
horizon.

These days, a bargain price means a price that is comparatively lower than prices for
other companies. For the past 20 years or so, investors who bought the 30 stocks that
combined a high return on capital with a high-earnings yield would have reaped a return
on investment (ROI) of 30% per year. In other words, $11,000 invested according to the
magic formula would have turned into $1,000,000 (before taxes and brokerage fees). By
comparison, the overall market on average returned slightly more than 12.3% annually
during this period.
However, the magic formula has a downside. It is an excellent long-term strategy, but
months and even years can go by during which it seems to be a losing proposition. To
use this formula successfully, investors must have faith and perseverance, which most
investors do not have so the formula simply will not work for them.

Why the Magic Formula Works

Notice that the magic formula combines two factors: high return on capital and highearnings yield. This formula works for large and small companies. It ranks companies
The Little Book that Beats the Market

Copyright 2006 getAbstract

4 of 5

This summary is restricted to the personal use of Rahul Muralidharan (rahul.muralidharan@in.prtm.pwc.com)

LoginContext[cu=2620045,asp=182,subs=0,free=0,lo=en] 2016-09-12 08:38:35 CEST

according to earnings yield and return on capital, and assigns a numerical rating to each
company. You can nd this ranking at www.magicformulainvesting.com. [getAbstract
note: Web addresses are subject to change.] Investors buy stock in the companies with
the best numerical ratings, hold them a reasonable length of time and sell them.

Companies that
achieve a higher
return on capital
are likely to have a
special advantage
of some kind.

The magic formula seeks superior companies at bargain prices. Companies with a
high return on capital are apt to be good organizations with, most likely, a distinctive
competitive edge. For example, Apples iPod has advantages in ease of use and market
acceptance. Cokes strong brand attracts more buyers than no-name beverages. eBay
was among the earliest Web auction sites, and has more liquidity and more trafc than
any other Web site. These companies can invest prots in activities that will continue
to earn a high return on capital, merely by reinvesting in what they are already doing.
So a higher return on capital can translate fairly easily into a high-earnings growth rate.
Businesses without a distinctive advantage are unlikely to give you a superior return. So,
merely by focusing on companies that earn a higher return on capital, the magic formula
eliminates many poor or mediocre businesses. This should provide some consolation to
investors during periods when the magic formula fails to beat the market.
As noted above, the magic formula sometimes stops working for a while because Mr.
Market gets moody and overlooks the real underlying value of companies. However,
investors have very little risk of loss over the long term because, although Mr. Market may
be irrational in the short term, over the long term Mr. Market does recognize value.

What It Takes to Use the Magic Formula

When you buy stocks from magic formula companies, phase in your investment, putting
about a quarter or a third of your investment amount in at each phase and buying half a
dozen or so stocks. Hold each stock for one year, then sell it and use the proceeds to buy
another stock according to the magic formula.
You can select magic formula stocks by checking the Web site noted above or by:

On Wall Street,
there aint no
tooth fairy!

Screening stocks according to return on asset (a proxy for return on capital) and
setting the minimum return at 25%.
Obtaining a list of the lowest P/E stocks.
When you have your list of potential stocks to buy, delete any of the following: all
utilities, all nancial industry stocks and all non-U.S. stocks. Also delete any stock
with a perversely low P/E, for example, less than ve, on the assumption that there is
a problem either with the time period or with the data for that company. Also delete
any companies that have recently made earnings or other signicant announcements,
because such announcements distort pricing.
Efcient market theory says that Mr. Market is a rational creature who incorporates
information into the prices of stocks. In the long term, Mr. Market does exactly that.
However, in the short term, Mr. Market is an erratic, volatile personality. The magic
formula lets you turn his volatility to your advantage when you invest.

About The Author

Joel Greenblatt is the founder and a managing partner of a private investment partnership
and hedge fund rm. He is an adjunct professor at Columbia Universitys business school
and the author of You Can Be a Stock Market Genius.
The Little Book that Beats the Market

Copyright 2006 getAbstract

5 of 5

This summary is restricted to the personal use of Rahul Muralidharan (rahul.muralidharan@in.prtm.pwc.com)

LoginContext[cu=2620045,asp=182,subs=0,free=0,lo=en] 2016-09-12 08:38:35 CEST