If you're a busy investor with more than just stock picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's Magic Formula.
Greenblatt details this approach in his enriching, funny The Little Book That Beats the Market. His strategy revolves around two factors:
- How cheap is the stock?
- How profitable is the company?
This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.
A cheap business and a profitable company
To find cheap companies, the Magic Formula looks for a high earnings yield -- basically, a company's EBIT divided by its enterprise value. EBIT is earnings before interest and taxes, otherwise known as operating earnings. Enterprise value includes the company's market capitalization, then adds its net debt. In general, the higher the earnings yield, the better. The Magic Formula looks for a yield higher than 10%.
To find profitable companies, Greenblatt's Magic Formula seeks businesses that generate pre-tax returns on assets greater than 25%. In other words, for every $100 in assets it holds, the company would produce at least $25 in net profit. In general, the higher the ROA, the better the business. Greenblatt looks for companies with an ROA higher than 25%.
So how do some of the biggest companies in airlines fare?
|
Company
|
Enterprise Value
|
EBIT
|
Earnings Yield
|
ROA
|
| China Southern Airlines (NYSE: ZNH ) |
$13,165 |
$984 |
7.5% |
5.0% |
| LAN Airlines |
$11,359 |
$586 |
5.2% |
8.3% |
| Ryanair Holdings |
$7,850 |
$835 |
10.6% |
7.4% |
| China Eastern Airlines (NYSE: CEA ) |
$10,718 |
$904 |
8.4% |
5.1% |
| Delta Air Lines (NYSE: DAL ) |
$18,278 |
$1,805 |
9.9% |
4.2% |
| Southwest Airlines (NYSE: LUV ) |
$6,988 |
$858 |
12.3% |
4.8% |
| United Continental Holdings (NYSE: UAL ) |
$11,321 |
$2,445 |
21.6% |
6.3% |
| TAM |
$6,872 |
$495 |
7.2% |
5.9% |
| Copa Holdings (NYSE: CPA ) |
$3,452 |
$394 |
11.4% |
13.7% |
| Alaska Air Group (NYSE: ALK ) |
$2,538 |
$493 |
19.4% |
9.4% |
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but six of them exceed our desired 10% earnings yield, and one more company comes close to meeting it. Such high earnings yields suggest the sector is out of favor.
While Delta has improved its situation since the worst part of the recession, it still has a long way to go to become attractive. Like many airlines, Delta suffered from a decrease in sales as customers cut expenses on leisure and business travel. The skyrocketing fuel prices also made it difficult for airline companies to make it through this period.
Delta and United Continental responded to these challenges by adding fees for baggage and food, as well as adding surcharges for fuel. Even after the economy began to improve, these airlines have continued to increase both fees and airfares.
Southwest Airlines has refrained from adding on these fees, but it has not seen Delta's improvements in financial performance. In fact, its latest quarterly earnings have fallen by nearly half from last year. While Southwest gained an increase in revenue from its acquisition of AirTran, it will now have to find a way to effectively integrate its new employees and assets into the rest of the business.
Foolish bottom line
The key advantage of the Magic Formula is speedy decision-making. You can run a screen and mechanically buy the stocks, then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), since you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year in order to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.
While this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his Magic Formula can significantly outperform the market.
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