Joel Greenblatt looks for cheap companies based on EBIT/ Enterprise value. This concept of cheap is inspired by Benjamin Graham.
Greenblatt also looks for quality companies. This is the qualitative concept he learned from Buffett. For quality Greenblatt looks for high returns on capital. Greenblatt believes that high returns on capital is the best measurement for finding the highest quality business.
Greenblatt for years taught his formula (cheap and quality) and believed it would outperform the market, but never conducted tests to prove it. Several years ago he looked at statistical data and it confirmed his formula.
Not only does the magic formula outperform the S&P 500, but the highest deciles of stocks in the Magic Formula outperform the lowest deciles. The stocks ranked the highest outperformed the stocks ranked the lowest within the Magic formula.
The formula has outperformed the market 72% to 5% since the book was published.
Greenblatt states that if you go through the list of stocks; there is a problem with every single one of them. Greenblatt says that since the companies are so cheap when they perform well they are able to compensate for the stocks that do not perform well.
The formula usually outperforms in both up and down markets.
Towards the end of the interview Joel Greenblatt discusses applying the magic formula towards international stocks.