Magic Formula

What it is\nFrom Joel Greenblatt's 2005 book The Little Book That Beats the Market. The "formula":\n\n1. Rank every stock by ROIC (highest first)\n2. Separately rank every stock by earnings yield (highest first, equivalent to lowest EV/EBIT)\n3. Add the two ranks together\n4. Buy the 20–30 stocks with the lowest combined rank\n5. Hold each for ~1 year, then rebalance\n\nThat's it. No qualitative judgement, no management assessment, no narrative.\n\n## Why it works\nThe formula combines Buffett's "good business" (high ROIC) with Graham's "fair price" (cheap on earnings). Mechanical screens force you to buy when stocks are out of favour and sell when they're popular — exactly the opposite of what most retail investors do.\n\nGreenblatt's own 17-year backtest (1988–2004): 30.8% annualised vs the S&P 500's 12.4%. Subsequent academic replications have confirmed the basic effect, though returns have moderated as the strategy became known.\n\n## Pitfalls\n- Concentration risk: 20–30 stocks in unrelated industries\n- Drawdowns: the formula has had multi-year underperformance stretches (worst: 3 years)\n- Behavioural challenge: half the holdings will look "obviously" wrong at the time of purchase\n- Tax drag: annual rebalancing creates short-term capital gains in taxable accounts