PDL BioPharma's Magic Formula

Do you want to invest in stocks but find that you have too many demands on your time to research companies? You have a demanding job, want to spend time with your family, and have a hobby or two.

If you want low-fuss investing options that aren't mutual funds or exchange-traded funds, you should consider a mechanical investing strategy. One of my favorites is Joel Greenblatt's Magic Formula. You can read all about it in his book The Little Book That Beats the Market. This is a great book because it is short, easy to read, and it will help you make money.

Is it cheap?
Value investing is a proven strategy, and the first part of the Magic Formula is to screen for stocks that are cheap. The valuation metric that Greenblatt uses in his book is the earnings yield, which he defines as EBIT / enterprise value. EBIT is the profitability (i.e., earnings) of the business before interest payments and taxes. Enterprise value reflects the market value of the company's stock -- its market capitalization -- plus the company's net debt. A company that is generating $1 of EBIT for every $10 of enterprise value has an earnings yield of 10%. For a stable business, the higher the earnings yield the cheaper the stock. The Magic Formula requires an earnings yield greater than 10%.

Is it a good business?
Sometimes stocks are cheap for a good reason. The business may be falling apart, for example. You wouldn't want to buy shares of a company that is statistically cheap if it is on its way to going out of business. This is why the second part of the Magic Formula is to screen for healthy businesses. Greenblatt recommends using return on assets greater than 25%. What that means is that for every $4 in assets -- things like inventory and manufacturing plants for example -- the company is able to generate $1 in after-tax profit. As a general rule, low ROA is a sign of a poor business and high ROA is a sign of a strong business.

Putting the formula into practice

Source: Capital IQ, a division of Standard & Poor's; author's calculations.

Here's an example of the Magic Formula applied to drug companies. With an earnings yield of 24.7% and an eye-popping 72.3% ROA, PDL BioPharma meets both Magic Formula criteria and would be purchased by an investor using this strategy. While its other drug company peers may have their own merits if you approach them with a fundamental analysis of their business prospects, they do not meet either of the Magic Formula criteria and would not be bought if you follow that mechanical approach.  

The Foolish bottom line
The advantage of the Magic Formula for the time-pressed investor is that all you need to do is run the screen and buy the stocks. You don't need to do all the time-intensive fundamental analysis most stock pickers do. Instead of figuring out if you trust management, analyzing the competitive landscape, or poring over financial statements, you get to spend your free time enjoying the activities you like.

Since there is no guarantee that any individual stock that meets these screening criteria will make you money, you need to buy a basket of stocks ranging from five to 30 companies. Once purchased, you hold them for a year to get long-term capital gains tax treatment. After one year has passed, you sell them all and run a new screen. Rinse and repeat.

Like many strategies, this mechanical approach doesn't work every year. Assembling your basket of stocks is the easy part. The hard part is psychologically sticking with the strategy when it's underperforming. That's an important part of making this approach work, and you have to be honest with yourself before you get started about whether you have the patience to stick to this strategy year in and year out. It does work, but you have to give it time. If you've used the Magic Formula before or are thinking of giving it a try, share your thoughts with the Fool community in the comments box below.