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In 1985, a young hedge fund manager named Joel Greenblatt founded an investment firm with only $7 million. During the next 20 years, that firm earned average returns of about 40% per year. That's one of the best track records in the history of Wall Street. So how did he actually do it? Not with a secret formula kept in some vault on Wall Street.
Greenblatt says his real secret can be explained by a simple story he told his own children. A story about a boy named Jason and the gum shops he built. If a bedtime story simple enough for a child can explain a 40% return, here's the question that should worry you. If it's really that simple , why hasn't everyone gotten rich doing it?
By the end of this video, you'll understand exactly what Jason's gum shops taught Greenblatt. You'll know it well enough to use it yourself. But first, you need to understand a question that most people never even ask themselves. What should you really do with your money? Imagine you have some money in your pocket right now.
You have a few options about what to do with it. You could keep it at home under your pillow. You could put it in a bank and earn a small amount of interest. You could lend it to the government by buying a bond, or you could use it to buy a small part of a real business. Here is the only comparison that matters more than any other.
Return versus risk. In the book, a safe 10-year government bond pays about 6% annually. That number becomes the basis for everything else. If a business can't offer a better return than that, why bother with the additional risk? This leads to a simple idea worth remembering. Your money always has another job it could be doing elsewhere.
Now, let's meet the boy who turned this idea into a real business. Jason grew up and built 10 gum shops all over town. The stores were doing well and Jason wanted to sell part of the business. So he divided the entire business into 1 million equal parts. Each part is called an action. Jason set the price of a share at $12.
That means Jason believes his entire business is worth $12 million . Now, imagine you buy 10,000 of those shares. You spend $120,000. You now own 1% of the entire company. This is the part that almost everyone misunderstands. You don't own a tiny corner of a gum shop somewhere . You own 1% of the entire business and its future profits.
That single idea is the foundation of everything else in this video. Now, let's take a look inside Jason's stores to see if business is really good. Last year, the 10 stores sold $10 million worth of chewing gum. Buying the chewing gum inventory cost $6 million. Operating the stores cost an additional $2 million .
That left $2 million in pre-tax profit . After paying 40% in taxes, Jason was left with 1.2 million. Now , remember, there are 1 million shares. So, each individual share earned $1.20 last year. You paid $12 for that stock. That means their profits are equivalent to 10% of what they paid. That sounds better than the 6% government bond we saw earlier.
But this is where Greenblatt stops us and says, "Wait ." Last year's profit is no guarantee of next year's. We still have to think about the competition, the uncertainty, and the years ahead." And that question leads us directly to the biggest idea in the entire book. If 10% sounds good, here's a question that will change how you view every stock price.
Is the price of something always the same as what it's actually worth? Most people think so. Greenblatt says absolutely not. And to explain why, he invented a fictional character. His name is Mr. Market, and he's a little crazy. Understanding Mr. Market is the key to understanding cheap and expensive stocks.
A stock has a price, but the company behind it is a real, living business. Those two things are not automatically the same. Imagine a small store that makes $1 million every year. Someone offers to sell it to you for $5 million . Now imagine someone else offers the same store for $50 million. The store hasn't changed at all.
Only the price has. This is exactly what Mr. Market does to real companies every day. Some days he gets excited and pays Too much. Some days he feels scared and offers very little, but the underlying business has barely changed. So, a smart investor never thinks that if the price has dropped, the company must be bad.
The real question is always: what is this business really worth compared to its price? Now we know that price is not the same as value, but that raises a second question. What makes a business good in the first place? Let's compare two imaginary stores. Jason's Gum Shop costs $400,000 to build. It earns $200,000 each year.
That's a 50% return on the money invested. Now meet Jimbo's Just Broccoli next door. It also costs $400,000 to build, but it only earns $10,000 a year. That's just a 2.5 % return. Same amount of money invested, completely different results. This is what Greenblatt calls return on equity. In simple terms, how much profit can a business extract from the money it needs to operate?
A high return on equity often means something special is happening. Maybe a strong brand, a better product, or a real advantage over competitors . But here's a twist. High earnings attract imitators. If anyone can easily copy the business, competition can cut into those earnings. So a high return matters when the business can actually back it up.
Now we've found tool number two. Let 's go back and get to know tool number one properly. Remember when Jason's stock was earning 10 % of its price? That number is called earnings yield. It simply means earnings divided by the price you pay. Imagine that the same $12 stock was earning $3.60 instead.
That would be a 30% earnings yield. The simple lesson is this: if the price stays the same , earning more is always better. This is really just another way of looking at the famous P/E ratio. A low price compared to earnings usually means a high earnings yield. But here's the catch: cheap doesn't automatically mean good.
A business can be cheap because it's genuinely in problems. Therefore , Greenblatt needs both tools working together, not just one. Tool one asks how cheap a business is compared to what it earns. Tool two asks how good the company is at converting capital into profit. Greenblatt combines both answers into a single ranking.
He calls it the magic formula. In simple terms, find a good business and buy it cheaply. Why not just buy the cheapest businesses you can find? Because some cheap businesses are cheap for a very good reason . Why not just buy the best businesses instead? Because even a wonderful business can be a bad investment if you pay too much for it.
The formula looks for something rarer than either of the two separately: a genuinely good business at a genuinely attractive price. But this raises the strangest question in the entire book. If a business is really that good, why would the market sell it cheaply? Wouldn't everyone want to own it already?
The answer says more about human behavior than mathematics. And understanding this answer is what separates the people who talk about investing from the People who are actually successful at it. Greenblatt's answer is simple. The stock market isn't calm or perfectly logical. In the short term, it's driven by emotions.
Investors get overly excited about novel companies and overly pessimistic about those going through a rough patch. So a business can quietly post great numbers while its stock is ignored and forgotten. The formula doesn't even need to know exactly why a stock is cheap. It simply looks for businesses that pass both tests simultaneously.
So, if the formula is that simple, here's the uncomfortable question: Why doesn't everyone use it and get rich? Because investing isn't just a math problem; it's also a behavioral problem. Imagine you follow the formula and buy a group of good, cheap companies. But the prices don't rise immediately.
Weeks, maybe months, go by. The market seems to completely ignore them. Meanwhile , other flashy stocks are soaring without you. This is precisely when most people quit. They start thinking, "This formula must be broken." “ Everyone else wins, except me.” Greenblatt says this discomfort is where discipline really matters.
A good strategy can look bad for a while and still work perfectly in the long run. If you quit every time you feel uncomfortable, the formula will never have a chance to work. Knowing the formula and having the discipline to stick to it are two very different things. So, how long does it usually take for the market to notice a bargain?
In the book, two or three years is usually enough time for the truth to come out . As the business continues to perform well, other investors gradually begin to notice. The company might buy back its own shares. A larger company might even want to acquire it. As attention grows, the price slowly approaches what the business was worth in the first place.
The most important word in that whole sentence is “eventually.” Patience isn’t an optional extra with this strategy. Patience is the strategy. Now, here’s another honest question worth asking. Should you pick these companies yourself? Greenblatt sincerely doubts that most people can accurately predict the The future of a single company.
Even professional analysts struggle to accurately forecast a company's earnings . So, instead of guessing, the book suggests a systematic, tedious, and repeatable process. Start with a large group of companies. Measure how well each one converts its capital into profit. Measure how much you earn compared to the price you pay.
Rank each company based on both numbers. Focus only on those that perform well in both. Then, create a diversified group instead of putting all your eggs in one basket. Why is diversification so important? Because even a great method sometimes picks a company that ends up underperforming. The future is always uncertain, no matter how good your formula is .
If you put everything into one company, one mistake can hurt you badly. If you spread your money across many companies, one mistake has much less power to harm you. A good method isn't a guarantee that every stock will be successful. It's a guarantee that the odds will be in your favor over time. Now, let's talk about why high returns can generate Even more growth.
If a business makes large profits, it can reinvest them in new opportunities. A gum shop cost $400,000 and earned $200,000 a year. So, opening a second, identical shop could add another $200,000 in profit. The business uses its own profit to create more, but capitalism always imposes a natural limit.
High profits attract competitors. More competition can drive down prices, steal customers, and reduce returns. This is exactly why a lasting competitive advantage matters so much. A high return on equity doesn't automatically last forever. If a business is easy to copy, that advantage can disappear over time .
But a business that keeps generating unusually high returns tells you something important. It probably has something special protecting it, like a strong brand or loyal customers. This is precisely why return on equity is such a powerful indicator. Let's put everything we've seen together from the beginning.
A stock is a small part of a real business. The stock price is simply what someone is currently asking for that part. The return on earnings It measures how much a business earns compared to its price. Return on equity measures how efficiently a business turns money into profit. The magic formula combines both ideas to find good businesses at bargain prices.
The hardest part isn't understanding the formula. The hardest part is having the patience to follow it when no one else seems to care. So, buy good businesses at low prices, diversify across many companies, and give the market time to notice what you already know. Here's a final image that sums up the whole book.
Imagine walking into a supermarket that has only two shelves. On the first shelf are the businesses. Some are powerful machines that turn little capital into big profits. Others struggle to make any money at all. On the second shelf are the prices. Some businesses are expensive because everyone is excited about them.
Others are temporarily unpopular and therefore cheaper. The magic formula walks down this aisle looking for one specific thing. An item that appears on both shelves at once. A solid business at a good price. That, in one image, is the entire book. Do you remember the question with which Shall we begin?
If this formula works so well, why isn't everyone using it already? Now you know the real answer. Most people know the formula, but few have the patience to follow it. Now you know something most investors never grasp: good business plus good price plus patience. That's the whole secret. If this story helped you, subscribe for more great ideas explained simply.
Comment with the next book you'd like me to review. Thanks for watching, and see you next time.
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