Joel Greenblatt, the book’s author, is a value investor extraordinaire and a professor at Columbia’s business school. In the book, Greenblatt discusses and justifies the “Magic Formula”, a stock selection method that allows individual investors to beat the market using value investing.
In these chapters, Greenblatt introduces two concepts which form the foundation of the Magic Formula: earnings yield, and return on capital.
Earnings yield is simply earnings divided by price. If a company was for sale at a certain price, a buyer would hope its earnings are high (relative to the price), not low. As such, a high earnings yield (or conversely, a low P/E) is desirable.
Return on capital is the money that a company receives from investing its own money. A company that can generate a higher return on capital is more desirable than a company that generates a low return on capital. A company that generates a return on capital less than the risk free rate is actually destroying capital.
By owning businesses that trade at high earnings yields and that have high returns on capital, investors will beat the market. To demonstrate this, Greenblatt examined the results of owning approximately 30 stocks with the best combination of earnings yield and return on capital over the last 17 years (since that’s how far back the Compustat “Point in Time” database went back). The portfolio returned 30.8% per year, compared to 12.3% for the overall market.
How were these portfolios constructed? All stocks in the market were ranked by the two criteria described above. The rankings were then added together. The top 30 combined-ranking stocks were considered the portfolio for the purposes of this study.