The Little Book That Still Beats the Market

What if you could consistently buy great companies at bargain prices—and double or triple your investment returns in the long run? That’s the tantalizing promise at the heart of Joel Greenblatt’s The Little Book That Beats the Market. Greenblatt argues that ordinary investors, even those without MBAs or Wall Street experience, can outperform most professional money managers by following a simple, rules-based approach he calls the magic formula. It’s not really magical—it’s just common sense dressed up in clear mathematics. And yet, Greenblatt shows that this method not only works but has worked for decades.

At its core, Greenblatt wants to answer one big question: how can regular people beat highly paid experts at their own game? The answer, he contends, lies in embracing two timeless principles of value investing: buy good businesses and don’t overpay for them. By combining these principles into a single, easy-to-follow formula—ranking companies by how profitable they are (return on capital) and how cheap they are (earnings yield)—you can build a portfolio that beats the market with less effort and less risk.

From Jason’s Gum Shops to Real-World Investing

Greenblatt opens the book like a teacher calmly explaining to his kids how money works. Through the fictional story of Jason’s Gum Shops—a sixth grader selling gum at school—he illustrates the basics of profit, return on investment, and the difference between a good business and a bad one. Jason makes a great profit margin. Meanwhile, Jimbo’s Just Broccoli stores are barely scraping by. The key difference? Jason earns high returns on the money he invests; Jimbo doesn’t. That distinction sets up one half of the magic formula: buy businesses that earn a lot relative to their invested capital.

The other half comes from another basic truth: even the best businesses aren’t worth buying at any price. Greenblatt connects this to Benjamin Graham’s famous teaching about Mr. Market—the manic partner who sometimes offers you shares of his business at wildly high or low prices. If you buy when he’s depressed and willing to sell cheap, you’ll make money. Thus, the formula doesn’t just look for good companies; it looks for good companies that Mr. Market is temporarily undervaluing.

The Magic Formula in Action

Here’s how it works. Greenblatt’s computer ranks thousands of U.S. companies by two things: their return on capital (how efficiently they use money to make more money) and their earnings yield (how much profit they make relative to price). Each stock gets a combined ranking, and the formula selects a basket of around 30 top-ranked companies. That’s it—no forecasts, no complicated financial models, no emotional trading. When Greenblatt back-tested this process over 17 years, he found it delivered average annual returns of roughly 30%, more than double the overall market average of 12%.

To ensure it wasn’t just luck, he tested across different company sizes—the largest 1,000 stocks, the largest 2,500, and so on—and across many time periods. Each test confirmed the same pattern: the top-ranked group outperformed the next, which outperformed the next, like clockwork. Even the biggest institutional investors could benefit because the formula worked equally well on large-cap stocks worth billions. The results were strikingly consistent, and the logic was deeply intuitive.

Patience, Belief, and Mr. Market’s Mood Swings

Of course, Greenblatt reminds readers that even the smartest formula can’t protect you from human impatience. The magic formula port­folio doesn’t beat the market every month or even every year—it can underperform for years at a stretch. That’s the cost of admission to superior long-term returns. Investors who don’t truly believe in the formula often abandon it right before it rebounds. This explains why it keeps working: most people can’t stick with it through rough patches. Belief and discipline, not numerical wizardry, are what separate successful investors from the rest.

Greenblatt connects this idea to real-world psychology and history. Like the British army clinging to old tactics during the American Revolution, many investors continue following strategies that once worked but no longer do. The edge accrues to those who understand timeless principles rather than temporary fashions. He also illustrates with anecdotes—money managers who quit after short-term poor performance only to watch their abandoned strategies later triumph.

Why Simplicity Wins

If this sounds too easy, Greenblatt concedes that’s exactly the problem. The hardest part of investing isn’t math—it’s behavior. Knowing that other investors will lose patience, the magic formula’s simplicity becomes its secret weapon. It works precisely because most people refuse to believe something so simple could outperform professionals. It’s a discipline, not a hunch—a way to systematically buy excellent companies when they’re unloved and reap rewards when the market’s emotions settle back to reason.

So when Greenblatt says you can “beat the market,” he isn’t offering a trick; he’s offering a philosophy: stick with rational, consistent, value-based thinking when everyone else is ruled by fear or excitement. That is the timeless key to wealth creation, whether through Jason’s gum, Coca-Cola stock, or your own investments. With discipline, faith, and time, you can harness the same logic that made Benjamin Graham and Warren Buffett legends—and still be home in time for dinner.

At the heart of Greenblatt’s message are two invaluable ideas: earnings yield and return on capital. These are the twin pillars that identify when a company is both good and cheap. If you remember nothing else, remember this: success in investing comes down to buying high-return companies at low prices.

Earnings Yield: Measuring Cheapness

The earnings yield shows how much you earn for each dollar invested. If Jason’s Gum Shops earned $1.20 per share last year and the stock price is $12, that’s a 10% yield ($1.20 ÷ $12). The higher the better. Comparing that to a 6% government bond rate, Greenblatt reminds you that no rational investor should settle for lower returns from a risky stock than from a guaranteed bond. So we want businesses with high earnings yields—companies that make a lot relative to their price.

Return on Capital: Measuring Quality

Yet high earnings don’t guarantee it’s a good business. Some firms earn a lot only by investing even more. That’s where return on capital comes in—it measures how efficiently a business turns invested money into profit. Jason’s Gum Shops, which earns $200,000 from each $400,000 store, pulls a remarkable 50% return. Jimbo’s Just Broccoli earns a meager $10,000 from the same investment—a 2.5% return. Jason has a wonderful business; Jimbo should just buy government bonds instead.

A high return on capital signals something special—a competitive advantage, a powerful brand, a strong niche, or efficient management. These are the “moats” Warren Buffett talks about. The best companies, like Apple or Coca-Cola, can reinvest profits at high rates of return year after year, compounding shareholder wealth.

Combining Value and Quality

The genius of Greenblatt’s magic formula is combining these two metrics. Many investors either buy only what’s cheap or only what’s high quality. Greenblatt proves that combining them is far more powerful. His ranking system identifies companies with both high earnings yield (cheap) and high return on capital (good). Those dual-ranked stocks, bought systematically, have been shown to outperform the market dramatically.

“Buying good companies at bargain prices is the secret to making lots of money.”

That simple formula captures 100 years of value investing wisdom in one line. Whether you’re Daniel-san learning wax-on, wax-off or a modern investor learning how to read a balance sheet, Greenblatt’s lesson is clear: the basics, applied consistently, lead to mastery.

After introducing the concept, Greenblatt does what few investment writers bother to do—he rigorously tests it. Using Standard & Poor’s Compustat ‘Point in Time’ database, which eliminates hindsight bias, he simulates what would have happened if investors followed the formula over 17 years ending in 2004. The results were staggering. A $10,000 portfolio using the formula would have grown to over $1 million, compared to roughly $79,000 for the market index. That’s the power of disciplined compounding.

Not Luck but Logic

Skeptics might dismiss such results as luck or data mining. But Greenblatt tackles this head-on. Across 4,500 distinct stock picks, the formula consistently ranks stocks in order of eventual performance: the top 10% outperform the next 10%, which beat the next, and so on. This orderly gradient suggests causation, not coincidence. The reason is behavioral: the market consistently overreacts to bad news and underprices temporarily troubled but fundamentally strong businesses.

Works for Big Money Too

Another major finding is that the formula works across company sizes. Critics often say small-cap anomalies can’t scale. But even when applied to just the 1,000 largest U.S. companies (each worth over $1 billion), it still nearly doubled market returns. This means it’s robust enough for large mutual funds, pension funds, and everyday investors alike. So it’s not a fluke hidden in obscure small stocks; it’s a principle that holds in big, liquid markets too.

There’s Always a Top 30

The beauty of a ranking system is permanence. No matter how expensive or cheap the overall market seems, some companies will always score highly relative to others. Unlike Benjamin Graham’s old formula, which could run out of bargains, Greenblatt’s method simply ranks and buys the top small group—there’s always a top 30 available. That flexibility makes the strategy evergreen in any market environment.

By testing the past, Greenblatt doesn’t promise the future—but he demonstrates that, statistically, the formula exploits a repeated inefficiency in human behavior. The numbers confirm the logic: people hate uncertainty and often discard great businesses prematurely. Buying from those people has always been a profitable long-term habit.

If this all sounds too easy—if it simply means following a mechanical system—why doesn’t everyone do it? Greenblatt’s answer is both fascinating and brutally honest: most people can’t stick with it. Even when handed a proven strategy, investors abandon it when short-term performance disappoints.

Short-Term Pain, Long-Term Gain

Throughout his 17-year study, the magic formula underperformed the market in about one out of every four years—and sometimes for as many as three years in a row. During those periods, investors saw others getting rich with trendy tech stocks or rising markets and lost faith. But those who endured the “pain years” were rewarded when performance snapped back powerfully. Greenblatt compares this behavior to money managers who quit right before their funds rebound, or clients who withdraw money at the worst possible moment.

Patience: The Rare Edge

In a world obsessed with quarterly performance, patience is the rarest advantage. Greenblatt jokes that the best thing about the magic formula is that it doesn’t always work. Why? Because if it worked every year, everyone would use it—and by chasing its stocks, they’d eliminate its edge. The fact that it periodically fails ensures its longevity. The few who can stay disciplined during droughts will enjoy the rewards when others give up. (Warren Buffett often says the same thing—“you can’t outperform if you can’t stand underperformance.”)

Belief Is Essential

Greenblatt insists you must truly believe in the formula’s logic to survive its lean years. Reading the book mechanically and copying the trades won’t work if you’ll panic and quit. Investment success comes not from IQ but from temperament—from sticking with rational strategies when human nature screams to do the opposite.

“If it worked all the time, everyone would use it. And if everyone used it, it would stop working.”

That paradox captures why even a public, well-known edge can persist indefinitely—as long as acting on it requires emotional strength most people lack.

Greenblatt returns again and again to Benjamin Graham’s character Mr. Market—an unpredictable partner who offers to buy or sell your shares each day at wildly different prices. His mood swings represent the emotional volatility of real investors. Understanding him is key to why the magic formula can beat the market.

Emotions Cause Mispricing

Over the short run, prices swing due to emotion, not value. Investors get euphoric about popular stocks and depressed about those facing temporary trouble. This emotional overreaction creates the very bargains Greenblatt’s formula exploits. Over the long run, though, “Mr. Market gets it right.” Facts eventually overpower feelings, and cheap stocks revert to fair value or beyond.

Why Time Heals All Mispricings

Greenblatt tells his MBA students he guarantees that if they value a company correctly, within two to three years, Mr. Market will agree. Why? Because time reveals truth. Uncertainty resolves. Companies buy back undervalued shares; acquirers snap up cheap firms; smart investors eventually notice value. The process may sting for a year or two, but patience ensures the payoff.

A Rational View of Risk

Wall Street academics often define risk in mathematical terms—price volatility or beta. Greenblatt scoffs at this. Real risk, he says, is the chance of permanent loss or failure to meet goals. By that definition, the magic formula, which favors safe, profitable, undervalued companies, carries lower risk than the market. Short-term price dips are not risk—they’re opportunity.

In redefining risk, Greenblatt not only educates new investors but also reframes courage: the courage to buy when Mr. Market is panicking and to hold when he’s euphoric. Being calm amid chaos is your real edge.

Having proved that the system works, Greenblatt gives clear, actionable steps for putting it into practice. The process is so straightforward you can learn it in five minutes—and yet its power compounds for decades.

Step-by-Step Process

• Use a ranking tool (like magicformulainvesting.com) to find top-rated companies by earnings yield and return on capital.
• Choose 20–30 of the highest-ranked stocks (more if you know less about analyzing them).
• Invest gradually—5–7 new stocks every few months until your portfolio holds 20–30.
• Hold each for about a year, selling winners after one year (to get long-term capital gains) and losers just before that (to claim tax losses).
• Replace sold stocks with new top-ranked picks and repeat for at least 3–5 years.

Over time, this rotation compounds tax-efficient gains while removing emotion from decision-making. It’s mechanical genius serving human weakness.

For Those Who Insist on Picking Stocks

In chapter eleven, Greenblatt addresses readers who refuse to follow formulas. He warns: picking individual stocks without knowing how to value businesses is like running through a dynamite factory with a burning match. But he concedes that if you can accurately predict “normal” earnings a few years ahead and can assess business quality, then owning 5–8 diversified bargains can work safely. For everyone else, stick to the formula—it’s your financial seatbelt.

Whether you automate your choices or custom-select from the top 100 ranked companies, following the formula protectively channels curiosity without losing discipline. It’s the DIY investor’s version of Warren Buffett’s partnership rules made simple for the twenty-first century.

One of Greenblatt’s toughest lessons comes late in the book: there’s no Tooth Fairy on Wall Street—no one responsible for making you rich while you sleep. Brokers, pundits, and mutual fund managers mostly talk more than they produce. The truth is you’re on your own, and that’s okay—because the tools to succeed are right in front of you.

Why the Pros Fail

The majority of mutual funds underperform the market once fees are deducted. Even those that beat it for a few years usually fall back. Success attracts money, big funds get unwieldy, and the edge dies. Hedge funds charge enormous fees and most don’t justify them. In short, the professionals have structural and psychological handicaps you don’t have: they can’t afford to be patient, different, or wrong for long.

Why Simplicity Wins Again

That’s why Greenblatt recommends index funds for the average hands-off investor and the magic formula for anyone seeking to outperform. Both are rule-based, transparent, and resistant to emotional sabotage. The difference is that the magic formula focuses your money on the undervalued tip of the iceberg rather than the whole cold sea.

In Greenblatt’s blunt conclusion, “putting your money under a professional’s pillow usually just gives you lousy performance.” Learning to rely on your own disciplined system isn’t just profitable—it’s liberating.

By the final chapters, Greenblatt turns philosophical. Once you’ve accumulated wealth using the magic formula, he asks: what will you do with it? Money itself is inert. Its highest use, he argues, is investing in things that improve society—especially education. Just as smart capital allocation drives successful businesses, investing in better schools multiplies social capital.

Applying Capitalism to Education

Drawing an analogy to businesses like “Just Broccoli,” Greenblatt criticizes failing public schools that never shut down and face no accountability. In capitalism, poor performers are replaced by better ones; in education, failures linger. He urges investments, reforms, and charities that reward excellence and redirect resources away from entrenched inefficiency. “If we applied capitalism’s feedback loop to schooling,” he writes, “we could stop wasting our future potential.”

The Real Return on Capital

Ultimately, Greenblatt’s appeal isn’t just for financial compounding but moral compounding. By using your profits to create opportunity for others, you achieve the highest return on capital—the return of meaning. When viewed that way, this “little book” becomes something larger: a guide not just to beating the market but to living wisely within it.

You started the journey learning how to make money; you end it learning how to make it matter. In Greenblatt’s view, that’s the most magical formula of all.