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101 of 107 people found the following review helpful
4.0 out of 5 stars Has Greenblatt discovered a "magic formula"?, August 15, 2006
This review is from: The Little Book That Beats the Market (Hardcover)
Joel Greenblatt's Little Book That Beats the Market (John Wiley, just released; $19.95), offers what the author says is a "magic formula" for success in the stock market. Such a phrase may arouse your skepticism, as it did mine, but let's look into the claim.

Joel Greenblatt founded and is a managing partner of Gotham Capital, a hedge fund that, according to reports, achieved a 50% annualized return [before payment of an incentive allocation] during the ten years (1985-1995) that it was open to outside investors. This kind of record certainly merits attention. Greenblatt, it's safe to say, has gotten rich.

Greenblatt's formula is based on only two measures: earnings yield and return on capital. These numbers are not hard to obtain. Greenblatt defines earnings yield as EBIT (earnings before interest and taxes) divided by enterprise value. Enterprise value equals a company's stock market capitalization plus debt plus preferred shares minus cash and cash equivalents on the balance sheet. Return on capital he defines as EBIT divided by the sum of net fixed assets (total assets minus depreciation to date) plus net working capital (current assets minus current liabilities).

One weakness of Greenblatt's presentation is the use of earnings as a measure. I prefer to look at a company's free cash flow (after subtraction of capital expenditures) rather than EBIT. Earnings are susceptible to a greater degree of manipulation than cash flow.

Second, the book does little to elucidate the qualitative measures that go into Greenblatt's investment process. Which businesses have a sustainable advantage? How do you identify growth? On the other hand, Greenblatt lays out a testable hypothesis--a real merit.

If you are interested in pursuing Greenblatt's idea's further, I recommend you visit his Website on MagicFormulaInvesting. At that site, you define a minimum capitalization size and a target number of stocks for your portfolio. The magic formula spits out a suggested investment set. A good number of the selections at present are in the areas of pharmaceuticals and technology.

Greenblatt presents some impressive numbers illustrating the back-tested historical results of his approach. These are, as the saying goes, no guarantee of future performance. The more money that follows Greenblatt's approach, the less it will return, over time. However, since Greenblatt's approach has a rational basis, you might also see a more rational allocation of capital to investments, which could reduce their volatility. By the same token, one rarely sees bargains anymore of the sort that Benjamin Graham outlined in Security Analysis (1st ed., 1934)--whereby companies could be bought for less than their net current assets--and the market is better for it. In that sense, financial theory is right in predicating that there is no "money machine" that markets--that is to say, competing investors--will not seek to arbitrage away.

(The author of this review, Andy Szabo, is founder of
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Showing 1-3 of 3 posts in this discussion
Initial post: Jan 31, 2011 4:56:43 PM PST
Last edited by the author on Jan 31, 2011 5:21:01 PM PST
Mike says:
He actually talks some more about the free cashflow bit in his other book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits especially when evaluating certain kinds of companies.

That other book was an excellent introduction to event-driven investing. I think this book is targeted to beginners a bit more. In fact, I think it begins to meander into "Get Rich Quick" territory. I doubt he ever actually used his "formula".

In general, the kind of people who need to reduce stock investing to this level should buy an S&P 500 index fund instead.

In reply to an earlier post on May 10, 2011 2:45:11 PM PDT
[Deleted by the author on Jul 6, 2011 6:27:18 AM PDT]

In reply to an earlier post on Jul 6, 2011 6:27:01 AM PDT
I think he answers that question in his book. The book says that an index fund buys an average stock at an average price. His method attempts to buy an above average stock at a below average price.
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