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 beverages fare?
|
Company
|
Enterprise Value
|
EBIT
|
Earnings Yield
|
ROA
|
| Coca-Cola (NYSE: KO ) |
$164,540 |
$10,114 |
6.1% |
12.4% |
| PepsiCo (NYSE: PEP ) |
$124,202 |
$10,103 |
8.1% |
13.4% |
| Anheuser-Busch InBev (NYSE: BUD ) |
$138,751 |
$11,929 |
8.6% |
10.2% |
| Ambev (NYSE: ABV ) |
$97,323 |
$5,838 |
6.0% |
24.0% |
| Diageo (NYSE: DEO ) |
$64,907 |
$4,225 |
6.5% |
13.3% |
| FEMSA (NYSE: FMX ) |
$24,890 |
$1,753 |
7.0% |
9.8% |
| Coca-Cola FEMSA |
$16,619 |
$1,347 |
8.1% |
14.7% |
| Brown-Forman |
$11,835 |
$820 |
6.9% |
22.3% |
| Coca-Cola Enterprises |
$10,254 |
$1,012 |
9.9% |
10.8% |
| Hansen Natural (Nasdaq: HANS ) |
$7,605 |
$433 |
5.7% |
35.5% |
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but Coca-Cola FEMSA just touches our desired 10% earnings yield and Hansen Natural exceeds our desired 25% ROA.
Coca-Cola provides several features that should be attractive to conservative investors because of the strong brand loyalty it commands and its growth opportunities in emerging markets. The company also offers a stable 2.8% dividend, which is nice in an environment where you can't always count on capital gains.
However, Coca-Cola's dividend is significantly lower than those offered by other giant beverage companies. For example, PepsiCo offers a 3.2% dividend and Dr Pepper Snapple offers a 3.4% dividend.
Anheuser-Busch InBev also offers several characteristics that should be attractive to conservative investors. It pays a 2% dividend yield that is supported by growth in its revenue and free cash flow over the past few years. The biggest worries include debt concerns that arose after Anheuser-Busch merged with InBev and its ability to continue to grow in the face of competition from increasingly popular craft beer companies such as Boston Beer.
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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