Most of us, myself included, are drawn to financial markets. Depending on how you approach it, call it trading or investing. There’s this allure, this promise of financial freedom that keeps us coming back. But here’s the thing – if we look at the track record of retail traders, it’s not exactly a highlight reel. It’s more like a blooper reel.

Why do we keep at it? There’s something about the whole process that lights up our brains. Is it the dopamine rush? It’s not unlike the rush a gambler feels in Vegas, only instead of slot machines, we’re watching candlestick charts. The question is: are we really investing, or are we just feeding an expensive habit?

While many chase hot stock tips, there’s a whole different approach to investing that’s been quietly making millionaires for decades. It’s called value investing, and it’s about as far from our dopamine-fueled trading as you can get.

Think of value investing as the sensible shopper of the investment world. Instead of buying whatever’s trendy, it’s all about finding good companies that are on sale. The godfather of this approach is Benjamin Graham. He wrote the bible on value investing back in the 1930s, and his most famous student, Warren Buffett, took the idea and ran with it all the way to the bank.

Value investing sounds simple in principle. Pick stocks that are cheap? However, cheap is relative. How do you know what’s actually a good deal? It’s like trying to figure out if that “designer” bag on the street corner is really worth it or just a knockoff. In investing, cheapness is relative to a company’s “intrinsic value.” Intrinsic value is what a company is really worth, not what the stock ticker is saying. But the thing is, figuring out the intrinsic value is as easy as solving a Rubik’s cube. Some are good at it, most are not.

Sure, we can dive into company’s books, crunch the numbers, and come up with an estimate. If you think that excites you, you can see Aswath Damodaran’s little book. However, most of us don’t have time for that. Even if we do, how much conviction would you have in a valuation you estimated?

Joel Greenblatt’s “Little Book That Still Beats the Market” is “Value Investing for Dummies.” The book is basically a crash course in value investing for those of us who cannot resist the temptation of buying individual stocks. Joel Greenblatt introduces the “Magic Formula,” which sounds like it belongs in a Harry Potter book, but it’s actually a systematizing Warren Buffet and Charlie Munger’s principle of buying wonderful businesses at fair prices.

What Did I Get Out of It?

What did I learn from this slim volume that promises to beat the market?

Greenblatt doesn’t just throw a formula at us and call it a day. He breaks down some fundamental principles of value investing in a way that even those who slept through Economics 101 can understand.

Markets are Irrational in Short Term

The stock market is like that friend who can’t make up their mind about where to eat dinner. One minute they’re craving sushi, the next they’re all about pizza. The market’s mood swings are just as dramatic and often just as irrational.

Each day the newspaper lists the names of thousands of companies and the price at which people have been buying and selling an ownership share in each. The trading back and forth of these ownership shares takes place in a number of locations and over computer networks. These ownership shares are referred to as shares of stock, and collectively, this buying and selling activity is referred to as the stock market.
So I ask the question again: How can this be? Can the value of General Motors, the largest car manufacturer in North America, change that much within the same year? Can a company that large be worth $30 billion one day and then a few months later be worth $60 billion? Are they selling twice as many cars, making twice as much money, or doing something drastically different in their business to justify such a large change in value? Of course, it’s possible. But what about the big price changes in IBM, Abercrombie & Fitch, and General Electric? Does something happen each and every year to account for large changes in the value of most companies?
No! It makes no sense that the values of most companies swing wildly from high to low, or low to high, during the course of each and every year.

We should not freak out every time the market has a tantrum. We should take those daily stock price swings with a grain of salt. Why? Because in the short-term, the markets are often irrational.

So why do share prices move around so much every year when it seems clear that the values of the underlying businesses do not? Well, here’s how I explain it to my students : Who knows and who cares? Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe it’s hard to decide what a fair rate of return on your purchase price is. Maybe people get a little depressed sometimes and don’t want to pay a lot for stuff. Maybe people get excited sometimes and are willing to pay a lot. So maybe people simply justify high prices by making high estimates for future earnings when they are happy and justify low prices by making low estimates when they are sad.

What can we do? If we are following Greenblatt’s playbook, then:

Don’t sweat the small stuff: Those daily or even monthly price swings? They’re often just noise. It’s like trying to judge a whole movie by a single frame.
Opportunity knocks: When everyone else is panicking over short-term fluctuations, that’s your cue to look for bargains. It’s like being the calm shopper on Black Friday while everyone else is wrestling over TVs.
Focus on value, not price: The stock price is just a number. The company’s actual value? That’s the real deal. Train yourself to see beyond the ticker tape.
Patience pays: If you’re constantly reacting to every market hiccup, you’re playing checkers while the pros are playing chess. Think long-term.
Keep your cool: When headlines are screaming about market crashes or booms, remember Greenblatt’s lesson. It’s your secret weapon for staying level-headed.

Secret to Buying Low and Selling High

Benjamin Graham introduced us to Mr. Market in The Intelligent Investor.

One of the greatest stock market writers and thinkers, Benjamin Graham, put it this way. Imagine that you are partners in the ownership of a business with a crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices. You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing.
Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business. On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.

Mr. Market as that slightly unhinged neighbor who’s always trying to buy or sell you stuff. Some days he’s offering you a mint condition Rolex for the price of a Happy Meal, other days he wants to sell you a rusty bicycle for the price of a Ferrari.

Here’s what this means for you:

Emotions are your enemy: Mr. Market is all about feelings, not facts. As an investor, you need to be the rational one in this relationship. When everyone’s panicking, that might be your time to go shopping.
Patience is your superpower: You don’t have to trade every day, or even every month. Wait for those moments when Mr. Market is being particularly irrational - in either direction.
Know your values: To spot when Mr. Market is irrational, you need to have a good idea of what companies are actually worth. Do your homework, and it’ll pay off.
Be contrarian: When everyone’s excited about a stock, it might be time to sell. When everyone’s doom and gloom, it could be time to buy. It’s like being the person who buys winter coats in summer.
The market is your servant, not your master: You’re in control. You decide when to buy, sell, or just relax and watch Netflix. Don’t let Mr. Market’s mood swings dictate your actions.

Practically speaking, this means developing a bit of a poker face when it comes to investing. It’s about making decisions based on value, not on what the crowd is doing or how you’re feeling that day.

Remember, successful investing is often about being comfortable doing what most others aren’t. When Mr. Market is having a fire sale, that’s your cue to go bargain hunting. When he’s on a euphoric buying spree, maybe it’s time to cash in some chips.

This approach isn’t about quick wins or day trading. It’s about playing the long game, being patient, and capitalizing on the market’s mood swings rather than being victimized by them. Master this, and you’re well on your way to buying low and selling high - the holy grail of investing.

Margin of Safety

Margin of safety is like wearing a seatbelt - it’s not there for the smooth rides, it’s there for when things get bumpy.

Ben Graham taught us that leaving a large margin of safety when we invest is the most important concept in investing. In other words, figure out what something is worth and then pay a lot less. Leaving a large spread between the value of a company and the price we pay will create a margin of safety and lead to long-term investment success.

Margin of safety is that it gives you room to breathe, to make mistakes, to learn. It’s the difference between walking a tightrope with or without a safety net.

In investing, it might mean buying a stock at a price well below its estimated value. In life, it’s about creating buffers that allow you to take calculated risks without fear of total wipeout. Just think about it:

In your career: Ever heard of having a “rainy day fund”? That’s margin of safety in action. It’s not just about saving money; it’s about developing skills beyond your current job. If your industry takes a nosedive, you’ve got a safety net.
In relationships: Building trust and goodwill is like creating a margin of safety. Those extra acts of kindness? They’re deposits in your relationship bank account, giving you a buffer when conflicts arise.
In health: Eating well and exercising regularly? That’s creating a margin of safety for your body. It’s like giving yourself extra hit points in a video game before facing the boss.
In time management: Leaving early for appointments or building buffer time into projects isn’t just about being punctual - it’s about creating a margin of safety against life’s inevitable curveballs.
In decision making: Considering worst-case scenarios isn’t pessimism; it’s smart planning. It’s about asking, “Even if this goes south, will I be okay?”

Life is unpredictable, like the market. Building margins of safety into different aspects of your life isn’t about being paranoid; it’s about being prepared. It’s the secret sauce that turns potential disasters into mere inconveniences.

So, next time you’re making a big decision - whether it’s in investing or in life - ask yourself: “What’s my margin of safety here?

Buying Wonderful Businesses at Fair Prices

This is where Joel Greenblatt introduces the “magic formula”. While Munger and Buffett buy their wonderful businesses by studying the businesses and meeting the management, we do not have the luxury to do that. Instead, we can rely on the formula. It’s not the same, but it’s best alternative out there.

The magic formula chooses companies through a ranking system. Those companies that have both a high return on capital and a high earnings yield are the ones that the formula ranks as best. Put more simply, the formula is systematically helping us find above-average companies that we can buy at below-average prices.

The formula operates on two key principles:

Return on Capital: This measures how efficiently a company uses its money to generate profits. A high return on capital indicates a quality business.
Earnings Yield: This is essentially the inverse of the P/E ratio (more on this later). It shows how much the company earns relative to its stock price. A high earnings yield suggests the stock might be undervalued.

The formula starts with a list of the largest 3,500 companies available for trading on one of the major U.S. stock exchanges.5 It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500. Similarly, the company that had the 232nd best return on capital would be assigned a rank of 232. Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield. The company with the highest earnings yield is assigned a rank of 1, and the company with the lowest earnings yield receives a rank of 3,500. Likewise, the company with the 153rd highest earnings yield out of our list of 3,500 companies would be assigned a rank of 153. Finally, the formula just combines the rankings. The formula isn’t looking for the company that ranks best on return on capital or the one with the highest earnings yield. Rather, the formula looks for the companies that have the best combination of those two factors. So, a company that ranked 232nd best in return on capital and 153rd highest in earnings yield would receive a combined ranking of 385 (232 + 153). A company that ranked 1st in return on capital but only 1,150th best in earnings yield would receive a combined ranking of 1,151 (1,150 + 1).

The formula ranks companies based on these two factors, then combines the rankings. The companies with the best combined scores are those that are both high-quality businesses (good return on capital) and potentially undervalued (high earnings yield).

This approach offers several advantages:

Objectivity: It removes emotional bias from the stock selection process.
Simplicity: It distills complex financial analysis into a straightforward ranking system.
Scalability: The formula can screen thousands of stocks quickly, something individual investors would struggle to do manually.

It’s worth noting that Greenblatt presents compelling statistics in his book, demonstrating how the magic formula has consistently outperformed the market over the long term. However, it’s important to remember that the book was published in 2010, which means some of this information may not reflect current market conditions.

Does the formula still work today? While I can’t provide a definitive answer, a quick search on Reddit and Twitter reveals that investors are still implementing and tracking this strategy in recent years.

It’s crucial to emphasize that this review is not an endorsement of this particular investment strategy. Rather, it’s a summary of the key lessons I’ve gleaned from Greenblatt’s book. I encourage you to conduct your own thorough research before making any financial decisions, as with any investment approach.

The Corporate Finance Lesson

The last take away is from the appendix of the book. I was particularly intrigued by Greenblatt’s choice of Return on Capital and Earnings Yield as his key metrics, as someone with a finance background. Why did he feel that these two measures capture the essence of value investing philosophy?

Return on Capital

Return on Capital = EBIT/(Net Working Capital + Net Fixed Assets)
Return on capital was measured by calculating the ratio of pretax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons.
EBIT (or earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using operating earnings before interest and taxes, or EBIT, allowed us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels. For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed).
Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in an ROA calculation) or equity (used in an ROE calculation). The idea here was to figure out how much Net working capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded from this calculation) but does not have to lay out money for its payables, as these are effectively an interest-free loan (short-term interest-bearing debt was excluded from current liabilities for this calculation). In addition to working capital requirements, a company must also fund the purchase of fixed assets necessary to conduct its business, such as real estate, plant, and equipment. The depreciated net cost of these fixed assets was then added to the net working capital requirements already calculated to arrive at an estimate for tangible capital employed.
Intangible assets, specifically goodwill, were excluded from the tangible capital employed calculations. Goodwill usually arises as a result of an acquisition of another company. The cost of an acquisition in excess of the tangible assets acquired is usually assigned to a goodwill account. In order to conduct its future business, the acquiring company usually only has to replace tangible assets, such as plant and equipment. Goodwill is a historical cost that does not have to be constantly replaced. Therefore, in most cases, return on tangible capital alone (excluding goodwill) will be a more accurate reflection of a business’s return on capital going forward.

Key points to note:

Focus on Operating Performance: Greenblatt emphasizes the importance of core operating performance by using EBIT instead of net income. This aligns with the principle in financial analysis that operating income is a better indicator of a company’s ongoing business performance, as it excludes the effects of capital structure (interest) and tax strategies.
Comparability Across Firms: The use of EBIT allows for better comparability across companies with different capital structures and tax situations. This is crucial in financial analysis when comparing companies within an industry or across sectors.
Capital Efficiency: Greenblatt is focusing on how efficiently a company uses its operational assets by using Net Working Capital + Net Fixed Assets as the denominator. This is a more refined approach than traditional ROA or ROE metrics, as it considers only the assets directly involved in generating operating income.
Working Capital Management: The inclusion of Net Working Capital highlights the importance of efficient working capital management, a key concern in corporate finance. It recognizes that payables are a form of interest-free financing, while receivables and inventory require funding.
Fixed Asset Utilization: Including Net Fixed Assets in the denominator emphasizes the importance of efficient utilization of long-term operational assets, a critical factor in many industries.
Exclusion of Goodwill: Greenblatt focuses on the tangible assets required for ongoing operations by excluding goodwill. This approach aligns with the concept of replacement cost in valuation theory and avoids distortions caused by historical acquisition costs.
Forward-Looking Perspective: The focus on tangible capital employed provides a more accurate reflection of the capital required to sustain the business going forward, which is crucial for forecasting and valuation purposes.

This also aligns well with value creation principles in corporate finance, focusing on the relationship between operating profits and the capital required to generate those profits. It’s a reminder that in financial analysis, it’s not just about the absolute level of profits, but how efficiently those profits are generated relative to the capital employed.

Earnings Yield

Earnings Yield = EBIT / Enterprise Value
Earnings yield was measured by calculating the ratio of pretax operating earnings (EBIT) to enterprise value (market value of equity + net interest-bearing debt).
This ratio was used rather than the more commonly used P/E ratio (price/earnings ratio) or E/P ratio (earnings/price ratio) for several reasons. The basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business.
Enterprise value was used instead of merely the price of equity (i.e., total market capitalization, share price multiplied by shares outstanding) because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings. By using EBIT (which looks at actual operating earnings before interest expense and taxes) and comparing it to enterprise value, we can calculate the pretax earnings yield on the full purchase price of a business (i.e., pretax operating earnings relative to the price of equity plus any debt assumed). This allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields.

Key points to note:

Comprehensive Valuation Metric: Greenblatt is employing a more comprehensive valuation metric by using EBIT/Enterprise Value instead of traditional P/E ratios. This approach is particularly relevant in corporate finance and M&A scenarios, where the focus is on the entire business rather than just the equity portion.
Capital Structure Neutrality: The use of Enterprise Value (equity + net debt) in the denominator neutralizes the effect of capital structure on valuation. This is crucial for comparing companies with different leverage levels, a common challenge in financial analysis and valuation.
Using EBIT maintains consistency with the Return on Capital metric and focuses on operational profitability before the impacts of financing decisions and tax strategies. This aligns with the principle of separating operating and financing decisions in corporate finance.
Cash Flow Perspective: This approach is more closely aligned with cash flow-based valuation methods, which are often preferred in corporate finance over pure earnings-based metrics. It provides a clearer picture of the cash-generating ability of the business relative to its total capital.
Acquisition Analysis: The EBIT/Enterprise Value ratio is particularly useful in M&A contexts, as it represents the unlevered yield an acquirer might expect when purchasing the entire business. This makes it a valuable tool for both buy-side and sell-side analysts in deal-making scenarios.
Industry Comparisons: This metric allows for meaningful comparisons across industries and companies with varying capital structures and tax situations. This is essential in sector analysis and portfolio management.
The Earnings Yield as defined here complements the Return on Invested Capital (ROIC) metric, providing a more rounded view of both the efficiency of capital use and the valuation relative to that efficiency, in alignment with ROIC.
Distressed Company Analysis: This metric provides more meaningful insights than traditional P/E ratios for companies with negative earnings or unusual capital structures.

This approach to Earnings Yield offers a more nuanced and comprehensive view of company valuation. It encourages a deeper analysis of how the market is pricing a company’s operating earnings power, considering the entire capital structure.

This metric aligns well with modern valuation techniques that focus on enterprise value and unlevered cash flows. It reminds financial analysts and corporate finance professionals to look beyond simple earnings multiples and consider the broader context of how a business is financed and valued as a whole.

Who is This Book For?

At its core, “The Little Book That Still Beats the Market” is a gateway to financial literacy for just about anyone. The beauty of Greenblatt’s work lies in its accessibility. It’s an ideal introduction to finance and investing for kids and teenagers, with its easy-to-understand language and storytelling approach. But don’t let that fool you – this book isn’t just for the young or financially uninitiated.

Whether you’re a college student trying to make sense of your first paycheck, a mid-career professional looking to optimize your savings, or a retiree aiming to preserve and grow your nest egg, there’s something here for you. Greenblatt’s book serves as a financial Rosetta Stone, translating complex investing concepts into ideas that anyone can grasp and apply.

But here’s the real kicker: the magic of this book isn’t just in Greenblatt’s famous formula. It’s in how he breaks down the principles of value investing without requiring you to have an MBA or a Bloomberg terminal. He doesn’t just tell you what to do; he explains why it works. This emphasis on understanding the strategy, not just blindly following it, is what sets this book apart.

Greenblatt offers a different kind of thrill for those of us who might get a rush from watching candlestick charts dance across our screens. It’s the satisfaction that comes from a well-thought-out, disciplined approach to growing wealth. Sure, it might not light up our brains like a jackpot on a slot machine, but it has the potential to light up our bank accounts in the long run.