The Little Book That Beats the Market is a classic book on investing in the stock market.

Author Joel Greenblatt gives an innovative method for choosing stocks.

It’s pretty impressive, honestly.

Here are his main ideas, and the “magical formula” he uses.

He actually refers to it as “the magic formula,” and it just may be.

Main Idea #1: Invest in Index Funds, If You Don’t Want to Put in the Work

I’ve said this before. Warren Buffett has has this before. So it’s nothing new. I’m not saying that Buffett and I are on the same playing field, I’m saying that I’ve said it before and an authority in the world of investing has said it before — two different perspectives indeed.

Let’s be honest, you really have two reasonable options when it comes to investing in the stock market:

  1. Spend a lot of time finding individual stocks.
  2. Invest in index funds if you don’t have the time for option one.

That pretty much sums it up. I mean, there are other options, but those are the two that make the most sense. Index funds have much lower fees than active mutual funds, and passive funds almost always beat active funds over the long haul, because around 80% of mutual fund managers don’t beat the market. The fact is, almost no mutual fund manager can beat the market, so why not invest in the market itself?

That’s exactly what an index fund does. An index fund is investing in the market.

Feel free to go read about it and see for yourself, but you’ll find it to be true. Index funds just make more sense than actively managed funds — over 80% of the time. So if you don’t want to put the time in to pick stocks (which takes a lot of time), invest in index funds.

You can open an IRA with TD-Ameritrade in less than 15 minutes and start investing in index funds right now.

If you’re still interested in picking stocks and actually beating the market, see main idea #2…

Main Idea #2: Use This Magic Formula to Pick Individual Stocks

Greenblatt gives a formula for picking stocks that has continually outperformed the market, unlike mutual funds.

In fact, over a 17-year period, from 1988 to 2004, a portfolio using “The Magic Formula” returned an average of 30% per year, versus the market’s 12% per year. So what is the magic formula? It’s slightly technical, so let’s define some terms:

  • Earnings Yield: A stock’s previous year’s earnings per share divided by the current share price.
  • Return on Capital (ROC): The after-tax profit divided by the book value of invested capital.

The earnings yield will be the factor that shows whether the stock is selling at a good price or not. So if a company’s previous earnings per share was $0.90, and the stock is trading at $20/share now, you would divide $0.90 by $20 and get 4.5 as the earnings yield. In this example, the earnings yield is pretty low, and the higher the better, so this one may not pass the test, but you get the idea of how to calculate it.

The return on capital (ROC) is important, because it shows how well a company can turn investment into profit. The ROC is basically the profit percentage, so if someone invested $100,000, and earned $10,000, their ROC would be 10%.

The idea is to buy stocks that have a high ROC, at a low price, and these two numbers above give you that information. These stocks are considered undervalued by Mr. Market. Greenblatt refers to the stock market as Mr. Market and he compares the market to an emotionally unstable person. The comparison makes a lot of sense, but don’t avoid investing just because the market reminds you of a crazy ex.

How the Formula Works

The actual magic formula Greenblatt gives you is calculated using the numbers we discovered above.

You start with a list of the largest 3,500 companies on the US stock exchanges (NYSE, NASDAQ, etc.), and then you rank them in order of their returns. The company with the highest ROC is in the first position, and so on. Now take the list of companies and rank them 1-3,500 according to earnings yield, with the highest is position one.

Now you score the companies…

The companies’ scores are determined by adding these two ranks together, so if a company ranked 15 on the first list and 952 on the second list, the company’s score would then be 967 (15+952=967). The companies with the lowest total score are considered the best buys in this formula.

Once you rank them, start buying. Greenblatt suggests that the more shares you buy, the better your chances of outperforming the market. He recommends buying at least 20-30 large companies (the top 20-30 stocks on the list). He says this works better with larger companies, so if you want to play it safe, stick with companies that are worth at least $50 million. TD-Ameritrade is also a great platform for buying individual stocks for your IRA.

After one year, you sell the stocks and do the formula all over again. Sell the losses just before the one year mark, and sell the gains just after one year so that they become “long-term” holdings.

Note: Don’t expect this formula to perform well every year. The reason professional money managers don’t use this formula is because they must constantly show returns, and this formula may go into the negative several years in a row, but over the long term (for retirement planning), this formula will beat the market and the money managers.

Combining the Main Ideas

The main ideas here are simple. One shows a way to invest easily if you don’t have the time to devote (index funds), and the other way shows a somewhat complicated method of manual investing that produces larger returns (The Magic Formula).

There is a way to basically combine these two ideas, but it doesn’t involved index funds. It simply involves automating The Magic Formula. Greenblatt has created an amazing tool. A resource that streamlines the entire formula.

Magic Formula Investing is a generator that shows you what the top 30 or 50 stocks are, according to The Magic Formula. Just to give you an example, here’s what the top 30 are right now (if you set the market cap at $50 million):

magic formula investing little book beats the market

The more stocks you own, the less risk. To get the overall, average performance of The Magic Formula, you need to own at least 20 stocks. Like I said earlier, the more, the better.

Make an effort to review the stocks, even if you use the generator (which you should definitely use). You don’t want to own too many stocks in one sector, but with companies this large, it shouldn’t be hard to spread your picks out.

The Magic Formula Quick Review

  1. Use the stock screener (or calculate the stocks manually)
  2. Buy at least 20 companies from the calculation (Start an IRA here)
  3. Sell the stocks after one year (losses just before a year, gains just after)
  4. Repeat step 1 and buy all new stocks — at least 20

This method will likely outperform the market by quite a bit, but it does involve more work.

If you prefer to not to do the work, buy index funds.

To read more about this investing method, read Greenblatt’s book: The Little Book That Still Beats the Market.