The Magic Formula for Communications

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 and 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 (ROA) 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 the communications equipment sector fare?

Company

Enterprise Value

EBIT

Earnings Yield

ROA

InterDigital (Nasdaq: IDCC  ) $1,442 $153 10.6% 15%
JDS Uniphase (Nasdaq: JDSU  ) $2,305 $87 3.8% 4.6%
Brocade Communications Systems (Nasdaq: BRCD  ) $3,055 $190 6.2% 5.5%
Juniper Networks (NYSE: JNPR  ) $8,854 $744 8.4% 7.7%
CIENA (Nasdaq: CIEN  ) $2,295 ($104) (4.5%) (5.3%)
Acme Packet $1,494 $79 5.3% 16.6%
Aruba Networks $1,811 ($3) (0.2%) (0.6%)
ADTRAN $1,832 $193 10.5% 24.1%
EchoStar $2,933 $111 3.8% 1.7%
ViaSat $2,438 $26 1.1% 1.7%

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of the companies meets both standards, but ADTRAN comes close, with an earnings yield above the Formula's desired 10% and an ROA within 1 percentage point of the Formula's desired 25%. The only other company that offers the Formula's desired 10% earnings yield is InterDigital, and its 15% ROA is above what is offered by most of its industry peers.

InterDigital patents wireless technology that big industry players such as Apple and Research In Motion use in their products, including their popular smart phones. Its shares rocketed last July as a result of speculation about the value of its intellectual property, but prices have steadily declined ever since.

JDS Uniphase has suffered along with other businesses in the optical-networking market last year after Finisar's shares went down in March and spooked investors holding shares of peers like JDS, Oclaro, and Oplink. Shortly afterwards, JDS reported strong earnings, but its share price has never recovered. However, since then JDS's earnings have once again declined and don't show signs of much improvement in the near-term.

Brocade is a storage-networking specialist that looked like it was well-positioned to benefit from the struggles of some of its competitors last year, when Cisco lost big clients IBM and Hewlett-Packard. Unfortunately for Brocade, it was unable to claim all that business, as HP has been decreasing its hardware business. In addition, earlier rumors of a buyout from HP, IBM, or Oracle have all but disappeared. However, hope for improvement lies a cloud-based-computing initiative with partners EMC and VMware.

Juniper Networks has attempted to distinguish itself from Cisco, Brocade, and others by putting a huge portion of its revenue into research and development. While this strategy may promote innovation, it also decreases earnings. And in response to a struggling economy, AT&T and Verizon spent less on networking equipment than usual in the second half of 2011, which resulted in a drastic drop in Juniper's share prices, followed by a fairly steady decline into the present.

Ciena posted strong third-quarter results, with growth in most of its segments and lower expenses. The network and optical equipment provider also reported an adjusted net income of $0.08 per share, which exceeded expectations of negative $0.08 per share. It also gained some clients, with 10% customer growth bringing in 17% additional revenue. Ciena's fourth-quarter results were not as strong, however, with reported overall losses despite rising revenues. It also has a huge pile of debt to service.

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 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.

The success of many tech companies is linked with the growing popularity of tablets and iPhones. If you'd like to learn more about how you can cash in on this booming market, check out our special free report, "3 Hidden Winners of the iPhone, iPad, and Android Revolution." It's available free for a limited time. Get your copy.

Jim Royal, Ph.D., owns shares of AT&T. The Motley Fool owns shares of IBM, Apple, EMC, and Cisco Systems and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of InterDigital, Cisco Systems, VMware, Apple, and Acme Packet and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1758319, ~/Articles/ArticleHandler.aspx, 11/28/2014 1:13:34 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 1 day ago Sponsored by:
DOW 17,827.75 12.81 0.07%
S&P 500 2,072.83 5.80 0.28%
NASD 4,787.32 0.00 0.00%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

11/26/2014 3:59 PM
BRCD $11.25 Down -0.15 -1.32%
Brocade Communicat… CAPS Rating: ****
CIEN $16.74 Down -0.01 -0.06%
Ciena Corp CAPS Rating: **
IDCC $50.85 Up +0.47 +0.93%
InterDigital Commu… CAPS Rating: *****
JDSU $13.46 Up +0.06 +0.41%
JDS Uniphase Corp CAPS Rating: ***
JNPR $22.20 Down -0.06 -0.27%
Juniper Networks,… CAPS Rating: **

Advertisement