💰 How to outperform the market by Joel Greenblatt

Joel Greenblatt is one of the best investors in the world.

Between 1985 and 2005, his Magic Formula compounded on average with 33% (!) per year.

I’ve read everything I possibly could about Greenblatt and summarized it for you in this article.

The Magic Formula

In 2006, Joel Greenblatt published his excellent book The Little Book That Beats The Market. The goal of this book was to explain his investment philosophy in such a simple manner that even his children could understand it.

Greenblatt’s main strategy was very straightforward: buy good companies which are cheap.

With this book, The Magic Formula was born. His strategy achieved an annual return of 33% between 1988 and 2004.

But how does The Magic Formula work?

The basic idea is very simple. You can do it in 8 easy steps:

1. Determine your investment universe

2. Calculate the earnings yield of all companies in your investable universe

3. Calculate the returns on capital of all companies in your investable universe

4. Rank all companies from highest earnings yield to lowest earnings yield

5. Rank all companies from highest return on capital to lowest return on capital

6. Buy the companies with the highest earnings yield in combination with the highest return on capital

7. Re-balance your portfolio every year

8. Continue this over the long term (at least 5 years)

You don’t want to do all calculations yourself?

Greenblatt does it for you on his website.

Here are the 30 most interesting US stocks according to Greenblatt’s strategy as of today:

Greenblatt’s Magic Formula is very similar to what we talked about in our article ‘Strategies that outperformed the market’.

But is it so simple? Can you outperform the market by using these simple formulas? The answer is yes.

But what’s the catch?

Never underestimate behavioral biases and investment psychology when you invest in these kind of strategies.

Let’s say that you started using The Magic Formula and you’re investing in small, unknown companies like Polished.com and Snail Inc. After 2 years, your return is equal to -28% while the S&P500 returned +15%. Would you pursue? Because that’s what needed to make this strategy a success.

For my own piece of mind, I’d rather underperform the market for a while owning companies like Mastercard, Adobe or S&P Global than Polished.com and Snail Inc. It will allow me to pursue the strategy during though times.

“Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row.” - Joel Greenblatt

10 Essential principles

Now you know everything about Joel Greenblatt’s Magic Formula, let’s dig a bit deeper in his core investment philosophy.

Here are 10 of Joel Greenblatt’s essential investment principles.

1. Don’t try to time the market

Timing the market is a fools game.

Market timing has nothing to do with being a successful investor.

The best investors focus on the fundamentals of a company.

“Unless you buy a stock at the exact bottom (which is next to impossible), you will be down at some point after you make every investment. Your success entirely depends on how dispassionate you are towards short term stock price fluctuations. Behavior matters.” - Joel Greenblatt

2. Buy good business at bargain prices

Buying a share of a good business is better than buying a share of a bad business.

You want to invest in companies which are able to reinvest their free cash flow at high rates of return.

“It turns out that 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 high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.” - Joel Greenblatt

Want to learn more about ROIC? Take a look here: What you need to know about Return On Invested Capital.

3. Know what you own

Investing is simple, but not easy.

Focus on easy companies in easy industries.

Always invest within your circle of competence.

“Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.” - Joel Greenblatt

4. You will underperform

By definition, you will underperform the market from time to time.

Always focus on the big picture.

When you are using a strategy that has proven to work in the long term, you’ll end up fine.

“Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period.” - Joel Greenblatt

5. Every investor is unique

You can borrow someone’s idea, but you can’t borrow their conviction.

Every investor is unique and has its own objectives.

As an investor, you are always running your own marathon.

“The odds of anyone calling you on the phone with good investment advice are about the same as winning the Lotto without buying a ticket.” - Joel Greenblatt

6. Focus on small caps

Small cap stocks are often less efficiently priced.

Why? Because big, professional investors aren’t interested in these companies.

Warren Buffett stated that he would be able to dramatically increase Berkshire Hathaway’s returns today if he would be able to invest in smaller companies.

If you want to gain a big advantage, you should focus on companies that aren’t followed by (many) analysts.

Source: What Works on Wall Street (Jim O’Shaugnessey)

7. Determine your risk appetite

Howard Mark once said that there are old investors and there are bold investors, but they are no old bold investors.

The best definition of risk is the permanent loss of capital.

Never make investments which will cause you to stay awake at night.

“Almost everyone should have a significant portion of their assets in stocks. But here it comes – few people should put all their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.” - Joel Greenblatt

8. The market will eventually be right

If your investment case was correct, Mr. Market will eventually pay you.

In the short term (1-2 years), the market is inefficient.

But in the long-term, the market always gets it right.

“Though not easy to do, even maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum time frame for any meaningful comparison of the risks and results of alternative investment strategies.” - Joel Greenblatt

9. Never underestimate incentives

Always look at management incentives.

How have they allocated capital in the past? Is their salary too high? Is there heavy insider buying or selling? What’s their track record?

“Show me the incentive, and I’ll show you the outcome.” - Charlie Munger

10. All intelligent investing is value investing

Every investor tries to do the same: buy a stock for less than what it’s worth.

Making a distinction between growth and value is useless as future growth is a crucial part of the value of a company.

Here’s what Warren Buffett has to say about the value versus growth debate:

More from Joel Greenblatt

Do you want to learn more from Joel Greenblatt? His 2 books are a must read:

• The Little Book That Still Beats The Market

• You Can Be A Stock Market Genius

Joel Greenblatt is also a professor at the University of Columbia. The beautiful thing about this? Here you can download all class notes (> 300 pages) a student of Greenblatt took during his courses:

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About the author

Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. We have read over 500 investment books and spend more than 50 hours per week researching stocks.