Joel Greenblatt Magic Formula - Simple System That Beats Wall Street

Most investing strategies sound complicated. Hundreds of variables, proprietary screens, neural networks, teams of PhDs staring at Bloomberg terminals. Then there is Joel Greenblatt, who built a system using exactly two metrics that beat the S&P 500 in 96 percent of tested periods. Two numbers. Rank them. Buy the top ones. Rebalance once a year. Go live your life.

As an engineer, this is the kind of elegance I respect. Not because it is simple for the sake of being simple, but because it strips away everything that does not matter and keeps only what works.

The Special Situations Era

Before the Magic Formula existed, Greenblatt was doing something different – and arguably even more impressive. From 1985 to roughly 2005, he ran Gotham Capital as a special situations fund. Special situations are corporate events that change a company in some structural way and scare away most market participants. Spin-offs, merger arbitrage, bankruptcy proceedings, mispriced merger securities. The stuff that makes institutional investors run the other direction.

His favorite was spin-offs. When a corporation takes a subsidiary or division and separates it into a new, independent company, distributing shares to existing shareholders. Most big funds dump the spin-off shares immediately. They did not ask for these shares. The spin-off is too small for their portfolio. Nobody on Wall Street covers it yet. So the stock gets hammered by indiscriminate selling, and for a brief window, you can buy a perfectly good business at a ridiculous price.

Greenblatt also played merger arbitrage and bankruptcy proceedings – distressed companies trading at prices that assume the worst possible outcome, even when reasonable analysis suggests significant recovery value.

The key to all of this was doing his own research. When you invest in situations others ignore, there is no analyst coverage, no CNBC segment, no consensus estimate. You are on your own. But that is the point – if you are one of the few people analyzing a particular opportunity, you are best positioned to assess whether the reward justifies the risk.

The Magic Formula – How It Works

Eventually, Greenblatt’s thinking evolved. Inspired by Warren Buffett’s approach of buying great businesses at fair prices, he formalized a quantitative system that could be applied systematically across the entire stock market. He called it the Magic Formula. Bombastic name, but the results speak for themselves.

Here is the entire system:

Step 1: Set a minimum market capitalization for your investment universe. This filters out micro-caps that are too illiquid or risky.

Step 2: Exclude utility and financial stocks. Their capital structures make standard valuation metrics unreliable.

Step 3: Exclude foreign companies, including those trading via American Depositary Receipts.

Step 4: Calculate two metrics for every remaining company:

• Earnings Yield = EBIT divided by Enterprise Value. This tells you how cheap the stock is. Higher is better.
• Return on Capital = EBIT divided by (Net Fixed Assets + Working Capital). This tells you how good the business is. Higher is better.

Step 5: Rank all companies by earnings yield. Separately rank them by return on capital. The best get the lowest rank numbers.

Step 6: Add the two ranks together for each company. If Coca-Cola ranks 245th for earnings yield and 365th for return on capital, its combined rank is 610.

Step 7: Buy 20 to 30 stocks with the lowest combined rank.

Step 8: Rebalance once per year. Sell losers one week before the one-year mark, winners one week after. This staggering minimizes capital gains taxes.

Step 9: Repeat. For years. Do not stop.

That is it. Two metrics. Cheap plus good. The formula identifies companies that are both high quality (they generate strong returns on the capital invested in the business) and undervalued (you are getting a lot of earnings per dollar of enterprise value).

Why It Works

The Magic Formula essentially combines Benjamin Graham’s insistence on buying cheap with Warren Buffett’s emphasis on business quality. It sits right in the middle of the growth-value spectrum.

Several things make this attractive for individual investors.

First, it is straightforward. Once-per-year rebalancing. A clear recipe. No subjective judgment calls about management quality or competitive moats. Numbers do the talking.

Second, it is systems-based. Removes the cognitive biases that destroy returns. You do not talk yourself out of buying because headlines are scary. You do not hold a loser because you are emotionally attached. The system decides. You execute.

Third, unlike traditional value investing where you might sit in cash when everything looks expensive, the rank-based nature ensures there are always stocks to buy. Even in an overheated market, some stocks rank better than others.

The performance backs this up. Over a 17-year testing period, the Magic Formula returned 30.8 percent per year. Independent researchers found somewhat lower numbers in replication attempts, but still meaningful outperformance versus the S&P 500. Conclusion holds either way: the strategy beats the broader market when implemented consistently.

The Long/Short Twist

Here is an interesting corollary: if stocks with the best combined ranks tend to outperform, stocks with the worst combined ranks tend to underperform. The Magic Formula simultaneously identifies the best and worst stocks in the market.

Greenblatt used this insight to build a long/short strategy at Gotham Asset Management. The approach involves buying stocks with low ranks (the good ones) and shorting stocks with high ranks (the bad ones).

Two examples from Gotham’s fund lineup illustrate how this works in practice:

• Gotham Absolute Return Fund: 120 percent long, 60 percent short, resulting in 50-60 percent net long exposure
• Gotham Enhanced Return Fund: 170 percent long, 70 percent short, resulting in 100 percent net long exposure

Important caveat: shorting is not for individual investors. A long-short strategy behaves like leverage – it amplifies returns in both directions. Even Greenblatt does not recommend this for retail investors. For the rest of us, the long-only Magic Formula is more than sufficient.

The Man Behind the Formula

Joel Greenblatt was born in 1957 in Great Neck, New York. His relationship with money and risk started early. At fifteen, he snuck into a greyhound racing track and bet what he describes as a small fortune on a dog with spectacularly fast times at shorter distances, not realizing the race was at a longer distance. The dog finished last. The 99-to-1 sure thing evaporated in under a minute.

As Greenblatt later reflected: without a basic level of knowledge and understanding, you cannot tell a great investment from a real dog. Literally.

He attended the Wharton School of Business at the University of Pennsylvania, earning a B.S. in 1979 and an MBA in 1980. While still a student, he published a study re-examining Benjamin Graham’s system of buying stocks at large discounts to intrinsic value. Conclusion: it works. That study connected him with Richard Pzena, who later founded Pzena Investment Management. Greenblatt remains a director there today.

After graduation, Greenblatt joined a firm specializing in merger arbitrage. Four years of hunting market inefficiencies. In 1985, he was ready to go out on his own.

Gotham Capital – The Numbers That Made History

Greenblatt started Gotham Capital in 1985 with 7 million dollars from Michael Milken, the junk bond king (who was later indicted for securities fraud, though that had nothing to do with Greenblatt or Gotham).

The performance over the first decade was extraordinary. Here are the actual numbers Greenblatt disclosed:

Annualized return for the decade: 50.0 percent.

Read that again. Fifty percent per year for ten years. One dollar became nearly fifty-two dollars. In the crash year of 1987, he returned 29.4 percent. In the recession year of 1990, he returned 31.6 percent. He never had a down year. Not once.

In 1995, Gotham returned all outside capital to its investors. From that point forward, only Greenblatt and his management team’s money remained in the fund. Performance beyond 1995 is known only to those inside the firm, but credible sources suggest approximately 40 percent annualized returns over the full 20-year period from 1985 to 2005. If true, every dollar invested from the beginning grew to approximately 836 dollars.

The traditional Gotham Capital fund was shut down in 2009 as Greenblatt shifted focus to Gotham Asset Management, which offers mutual funds using the Magic Formula-inspired long/short strategy for both retail and institutional investors.

How It Works Today

Greenblatt built a free website – magicformulainvesting.com – that provides real-time Magic Formula ranking data. You pick your market cap threshold, and it spits out the highest-ranked stocks. He has stated it will remain free forever.

The strategy is fully transparent. No secrets, no black boxes. Anyone can implement it.

So why does it not stop working if everyone knows about it? Patience. The Magic Formula underperforms in roughly one out of every four years. Most investors abandon strategies that underperform even briefly. They chase last year’s winners. They panic when their portfolio lags the S&P 500 for a few quarters. Human psychology is the moat that protects this strategy.

Key Takeaways

Cheap plus good is the entire formula. Earnings yield measures cheapness. Return on capital measures quality. Rank by both, buy the top scorers. Two variables capture most of what matters.

Systems beat judgment. A mechanical, rules-based approach removes the emotional decisions that destroy returns. You do not need to be smarter than the market. You need to be more disciplined.

The strategy works because people cannot stick with it. It will underperform in some years. That is when most investors quit. If you can hold through the down periods, you collect the premium that the quitters leave behind.

Special situations are real edges, but harder to execute. Spin-offs, merger arbitrage, and bankruptcy plays generated Greenblatt’s legendary 50 percent returns. They require deep research and tolerance for ugly situations. The Magic Formula is the systematized, accessible version of the same insight: buy good things cheap while everyone else runs away.

Do your own work. If you rely on someone else’s analysis, you are already behind. The best opportunities exist precisely where no one else is looking.