Greenblatt Magic Formula
The Greenblatt Magic Formula is a systematic value investing strategy introduced by hedge fund manager Joel Greenblatt in his 2005 book 'The Little Book That Beats the Market' that ranks stocks by the combination of earnings yield and return on invested capital, buying the highest-ranked companies on both measures simultaneously to identify businesses that are both cheap and of high quality.
Joel Greenblatt developed the Magic Formula to operationalize the core insight of Warren Buffett's investment approach: buy good businesses at cheap prices. Most value investors focus on either cheapness (buying low P/E or low price-to-book stocks) or quality (seeking high-return businesses), but few systematic strategies combined both criteria. Greenblatt found that ranking stocks by the sum of their earnings yield and return on invested capital ranks, then buying the top-ranked securities, produced compelling historical returns.
Earnings yield in Greenblatt's formulation is EBIT divided by enterprise value (the inverse of the EV/EBIT multiple), which adjusts for capital structure differences by measuring earnings relative to the total market value of the business rather than just the equity market cap. A company with $100 million in EBIT trading at an enterprise value of $500 million has an earnings yield of 20 percent. Using enterprise value rather than market cap avoids artificially ranking highly leveraged companies as cheap simply because their equity cap is small relative to earnings.
Return on invested capital in Greenblatt's framework is EBIT divided by net working capital plus net fixed assets, measuring how efficiently the business converts its tangible capital base into operating earnings. A business earning $100 million in EBIT on a tangible capital base of $500 million has a 20 percent ROIC, suggesting a high-quality operation. Using tangible capital only (excluding goodwill and acquired intangibles) ensures the ratio reflects the returns generated by the actual operating assets rather than the premium paid in historical acquisitions.
Greenblatt back-tested the strategy on the largest 3,500 U.S. stocks from 1988 to 2004 and found annualized returns of approximately 30 percent, substantially exceeding the S&P 500. Academic replication studies have generally confirmed the strategy's historical outperformance, though with smaller return premiums in more recent periods as the strategy became widely known and at least partially arbitraged.
Practically, the strategy requires rebalancing the portfolio annually, replacing the prior year's holdings with a fresh list of high-ranking stocks. Greenblatt acknowledged that the strategy underperforms the market in roughly one out of every four calendar years, requiring investors to hold through periods of frustration — a behavioral challenge that he suggested explains why the anomaly persists despite public awareness.