The Little Book by Joel Greenblatt

Author:Joel Greenblatt
Language: eng
Format: epub
Publisher: John Wiley & Sons, Inc.

Chapter Nine

VOMIT UNDER THE 3EM-SPACES AND RUN!”

Now there’s a saying you don’t hear every day. The main reason you don’t hear it much is pretty straightforward. Over time, the phrase has lost all of its meaning. In fact, I really only needed it to pass my eighth-grade course in print shop.

You see, old-time printers used to set type by hand and actually picked letters individually out of a box. To pass the course, my fellow middle schoolers and I were forced to memorize the location of these letters. The letters in the bottom row were V-U-T, then something called a 3em-space, followed by the letters A-R. We remembered the order by the catchy phrase “Vomit under the 3emspaces and run!”

With the advent of computers, my little memory device–and print shop, for that matter–is now useless. Of course, the world has changed a lot since I was in middle school. No one teaches print shop anymore. Thankfully, though, some subjects haven’t changed. Math class, for one, is still pretty much the same. As investors, that’s really important to know.

That’s because, in order for the magic formula to make us money in the long run, the principles behind it must appear not only sensible and logical, but timeless. Otherwise, there is no way we’ll be able to “hang on” when our short-term results turn against us. As simple as it may seem, knowing that two plus two always equals four can be a pretty powerful concept. No matter how many people tell us differently, no matter how long they tell us, and no matter how smart all those people appear to be, we are unlikely to waver in our conviction. In a similar way, our level of confidence in the magic formula will determine whether we can hang on to a strategy that may be both unpopular and unsuccessful for seemingly long periods of time.

So what is it about the magic formula that makes sense–so much sense, in fact, that we won’t waver when things turn against us? Well, let’s take another look.

The magic formula chooses companies through a ranking system. Those companies that have both a high return on capital and a high earnings yield are the ones that the formula ranks as best. Put more simply, the formula is systematically helping us find above-average companies that we can buy at below-average prices.

That certainly sounds logical and sensible. If, indeed, that’s what we’re really doing, it also sounds like a strategy we can truly believe in. So, let’s go step-by-step and see whether that’s true.

First, why are companies that earn a high return on capital so special? What kind of companies is our formula telling us to buy? What makes them above average? To understand the answers to those questions, let’s go back and check in with our old friend Jason.

Last year, as you may remember, was a pretty good year for Jason’s business. Each of his gum shops earned $200,000. Since he only had to invest $400,000 to build each store (including inventory, store displays, etc.

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