Book summary “The little book that still beats the market”: summary

Introduction

You want to grow your wealth through the stock market, but professional advice often leaves you trailing behind index funds. Traditional stock picking requires endless analysis, insider knowledge, or complex forecasting that rarely delivers consistent results. You face a confusing landscape of market hype, emotional trading decisions, and conflicting expert opinions.

The author argues that you can consistently beat the market by systematically buying shares of good companies at bargain prices using a simple quantitative formula. Instead of predicting the future, you focus entirely on a business's current earnings power and purchase price.

This book guides you through that strategy across four clear steps. You learn how to value a business correctly, how the ranking formula works, why psychological discipline matters, and how to execute trades yourself. You discover answers to specific practical questions:

• How do you determine the true value of a business?
• What metrics identify a high-quality company selling at a discount?
• Why do most investors fail even when using a winning strategy?
• How many stocks should you hold, and when should you sell them?

1. Valuation and Mr Market

Buying a stock means purchasing a percentage of a real business and acquiring a claim on its future earnings. Evaluating a business involves projecting its future earnings, subtracting costs and taxes, and dividing total value by the number of shares outstanding to determine per-share value. You look past ticker symbols and daily price quotes to see the underlying company.

Buying a stock means purchasing a percentage of a real business, and safe profits come from buying when emotional market swings create a deep margin of safety.

Joel Greenblatt uses his son Matt's classmate Jason, who sells packs of gum for 25 cents per pack with 5 sticks per pack to make a profit of one dollar per pack, to illustrate how to value a small business. Jason's Gum Shops generate $1,200,000 in net income after expenses and taxes. The total business value translates to a $12 per share price with 1 million shares outstanding. You review the income statement and calculate the per-share value using shares outstanding.

Evaluating a Business

Valuation relies on basic math rather than complex forecasting. You determine what cash the business will generate over time and discount it back to the present. The process treats you as an owner rather than a speculator.

Market Volatility and Mr Market

The stock market acts like an emotionally unstable business partner named Mr. Market who offers wildly fluctuating prices every day. Share prices for large, stable companies swing widely over short periods even though the underlying value of the businesses does not change dramatically. You can ignore these mood swings or use them to your advantage.

General Electric, IBM, General Motors, and Abercrombie & Fitch experienced massive high and low share price ranges within a single year despite the underlying businesses remaining relatively stable. General Electric traded at $35 per share with a yearly high of $53 and low of $29. General Motors fluctuated near a $37 per share price with a yearly range between $30 and $68.

Safe and reliable investment profits come from purchasing shares only when they trade at a large discount to their estimated intrinsic value. By waiting for Mr. Market to be in a depressed mood and offer shares at a steep discount, an investor creates a buffer that protects against calculation errors or unexpected business downturns. You demand this margin of safety before committing capital.

2. The Magic Formula Mechanics

The magic formula ranks the largest U.S. companies by earnings yield and return on capital, identifying high-quality businesses available at bargain prices.

Earnings Yield and Return on Capital

You calculate earnings yield by dividing a company's annual earnings per share by its share price. This metric shows the return on investment relative to the purchase price.

Jason's Gum Shops earns $1.20 per share on a $12 share price, yielding 10 percent. If it earned $2.40 or $3.60 at the same $12 price, the earnings yield would rise to 20 percent or 30 percent respectively. You can compare this 10 percent earnings yield favorably against a risk-free 10-year U.S. government bond yield of 6 percent.

Return on capital measures how efficiently a business generates earnings from the initial capital required to build or operate its facilities.

Jason's Gum Shops costs $400,000 to build a store and earns $200,000 annually, delivering a 50 percent return on capital. This store vastly outperforms Jimbo's Just Broccoli stores, which cost $400,000 to build and earn only $10,000 annually, representing a 2.5 percent return on capital.

Backtested Performance Results

The magic formula ranks the largest U.S. companies by return on capital and earnings yield separately, then combines those ranks to find companies with the best overall score.

• Start with a list of the largest 3,500 companies available for trading on major U.S. stock exchanges.
• Assign a rank from 1 to 3,500 to each company based on their return on capital.
• Assign a rank from 1 to 3,500 to each company based on their earnings yield.
• Combine the two rankings by adding the return on capital rank and earnings yield rank together.
• Select the companies with the best combined rankings.

A company ranking 232nd in return on capital and 153rd in earnings yield receives a combined ranking of 385. This score easily outranks a company ranked 1st in return on capital but poorly ranked in earnings yield.

Historical tests over a 17-year period show that a portfolio of approximately 30 stocks selected by the magic formula significantly outperformed the overall market averages.

Over the 17-year period from 1988 to 2004, the magic formula portfolio returned roughly 30.8 percent per year. An initial investment of $11,000 in the magic formula portfolio turned into well over $1 million during this timeframe. Meanwhile, the overall market returned an average of 12.3 percent per year, turning an initial $11,000 investment into $79,000.

3. Psychology and Persistence

Inevitable periods of short-term underperformance cause most investors to abandon the strategy before long-term statistical advantages can materialize.

The magic formula portfolio frequently underperforms the overall market over short periods such as months or even several consecutive years. Historical statistics show the formula fared poorly relative to market averages in 5 out of every 12 months. It failed to beat the market once every four years and experienced multi-year slumps lasting up to three consecutive years.

A bestselling investment author who opened a fund based on his tested formula saw it underperform for two of its first three years. He lagged by 25 percent in one year and sold his management company, missing the subsequent stellar recovery. Because investors and professionals have short time horizons, they tend to quit during these lumpy performance phases. Another professional money manager experienced 3 or 4 years of underperformance before managing over $10 billion with only 4 original clients remaining.

Three-Year Consistency

Holding a magic formula portfolio over a three-year period dramatically reduces risk and increases the probability of positive returns and market outperformance.

Historical tests over 193 separate one-year periods show that following the formula for any three-year period in a row yielded positive returns 100 percent of the time during the 17-year test period. The largest 3,500 stocks with market values over $50 million beat the market averages in every single three-year test period, succeeding 160 out of 169 periods, or 95 percent of the time.

The worst return for the magic formula over a three-year period was 11 percent, while the market averages suffered a worst loss of 46 percent over a three-year period. Bargain prices eventually move toward fair value due to three primary forces: smart investors recognizing discrepancies, companies repurchasing their own undervalued shares, and corporate takeovers or buyout bids by larger firms. It usually takes 2 to 3 years for Mr. Market to reward bargain purchases with a fair price.

Most people should not pick individual stocks on their own unless they possess the rare ability to estimate normalized earnings several years into the future. While the magic formula successfully uses last year's earnings because it operates across a broad portfolio of 20 to 30 stocks, individual stock pickers must forecast normal earnings across a multi-year horizon to avoid short-term operational anomalies.

You can apply professional methods by following specific steps:

• Estimate normalized earnings several years down the road for a business you understand well.
• Calculate earnings yield and return on capital based on your estimates of normal earnings.
• Limit your portfolio to five to eight bargain-priced stocks in different industries if you are an expert.

Investors who insist on picking individual stocks without deep valuation expertise can combine the magic formula with personal favorites. You can use a compromise strategy where you start with the magic formula's top-ranked output and select a handful of favorites strictly from that curated list.

You should implement this hybrid approach through clear actions:

• Start with the magic formula and put together a list of top-ranked stocks.
• Choose a few of your favorites solely from the top 50 or 100 stocks as ranked by the formula.
• Place at least 10 to 30 stocks in your portfolio depending on your level of evaluation skill.

4. Step-by-Step Implementation

Successful execution requires building a diversified portfolio of twenty to thirty stocks using dedicated screeners and disciplined tax optimization.

Portfolio Building Instructions

You can implement the magic formula using a dedicated online screener by building a diversified portfolio of 20 to 30 stocks over time. The process requires selecting market capitalization thresholds, buying five to seven top-ranked stocks every few months until fully invested, holding each stock for one year, and maintaining the discipline for at least three to five years.

• Go to magicformulainvesting.com.
• Follow the instructions for choosing company size. For most individuals, companies with market capitalizations above $50 million or $100 million should be of sufficient size.
• Follow the instructions to obtain a list of top-ranked magic formula companies.
• Buy five to seven top-ranked companies. To start, invest only 20 to 33 percent of the money you intend to invest during the first year.
• Repeat the previous step every two to three months until you have invested all of the money you have chosen to allocate to your magic formula portfolio.
• Sell each stock after holding it for one year. For taxable accounts, sell winners after holding them a few days more than one year and sell losers after holding them a few days less than one year. Use the proceeds from any sale and any additional investment money to replace the sold companies with an equal number of new magic formula selections.
• Continue this process for many years. 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.
• Feel free to write and thank me.

When you use general stock screeners instead of the dedicated website, you must filter for high return on assets, low price-to-earnings ratios, and exclude financials, utilities, and foreign receipts. General screeners approximate the magic formula by substituting return on assets for return on capital and P/E ratio for earnings yield, while removing distortions from regulated industries and foreign firms.

• Use return on assets as a screening criterion. Set the minimum return on assets at 25 percent.
• From the resulting group of high return on assets stocks, screen for those stocks with the lowest price-to-earnings ratios.
• Eliminate all utilities and financial stocks from the list.
• Eliminate all foreign companies from the list. In most cases, these will have the suffix American Depository Receipt after the name of the stock.
• If a stock has a very low price-to-earnings ratio of 5 or less, that may indicate that the previous year or the data being used are unusual in some way. You may want to eliminate these stocks from your list.
• You may also want to eliminate any company that has announced earnings in the last week.
• After obtaining your list, follow the fourth and seventh steps from the magicformulainvesting.com instructions.

Tax Optimization Strategy

Taxable accounts can boost after-tax returns by strategically timing the sale of winning and losing stocks around the one-year holding mark.

Selling losing stocks a few days before the one-year holding period allows them to qualify for short-term capital loss deductions against high-taxed income. Selling winning stocks a few days after one year grants them lower long-term capital gains tax rates.

Conclusion

Combining high earnings yield with high return on capital creates a robust edge over market averages by systematically capturing both value and quality. Emotional market swings routinely misprice good businesses, and your disciplined approach allows you to profit from those temporary distortions. You must follow a strict process to let statistical probabilities work in your favor over multi-year periods.

1. Calculate or screen for the top thirty large-cap U.S. companies using the combined rankings of earnings yield and return on capital.
2. Invest equal amounts of your starting capital in five to seven of these qualified stocks each quarter until your portfolio reaches twenty to thirty holdings.
3. Hold each selected stock for exactly one year to maximize tax efficiency and allow the underlying business value to materialize.
4. Sell every holding after one year, replace any company that no longer qualifies, and repeat the quarterly purchasing cycle with new selections.
5. Ignore short-term underperformance and maintain your systematic routine even when the broader market falls or rises sharply.

10 Key Ideas

1. Buying a stock means purchasing a percentage of a real business, and safe profits come from buying when emotional market swings create a deep margin of safety.
2. Valuation relies on basic math rather than complex forecasting to determine what cash a business will generate over time and discount back to the present.
3. The stock market acts like an emotionally unstable business partner named Mr. Market who offers wildly fluctuating prices every day.
4. The magic formula ranks the largest U.S. companies by earnings yield and return on capital, identifying high-quality businesses available at bargain prices.
5. Return on capital measures how efficiently a business generates earnings from the initial capital required to build or operate its facilities.
6. Historical tests over a 17-year period show that a portfolio of approximately 30 stocks selected by the magic formula significantly outperformed the overall market averages.
7. Inevitable periods of short-term underperformance cause most investors to abandon the strategy before long-term statistical advantages can materialize.
8. Holding a magic formula portfolio over a three-year period dramatically reduces risk and increases the probability of positive returns and market outperformance.
9. Successful execution requires building a diversified portfolio of twenty to thirty stocks using dedicated screeners and disciplined tax optimization.
10. Taxable accounts can boost after-tax returns by strategically timing the sale of winning and losing stocks around the one-year holding mark.