The Magic Formula for These Hardware Stocks

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 computers and peripherals sector fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of these companies meets both standards, but Apple comes close, with an earnings yield within 1 percentage point of the Formula's desired 10% and 4 percentage points higher than the Formula's desired 25%. In fact, Apple is the only company here that meets the Formula's 25% ROA standard. Several companies meet the earnings yield standard, however, including SanDisk, Hewlett-Packard, Dell, and Western Digital.

Apple's huge cash pile and massive growth make it an appealing investment. However, the company's failure to pay a dividend despite those large cash holdings makes it less attractive for conservative investors who crave those reliable payments. However, the company has even managed to continue to grow its sales and free cash flow during the recession. This is at least partially due to recent innovations that have maintained its popularity, including its hugely popular iPhone and iPad. In fact, the iPhone is so popular that companies like AT&T, Verizon, and Sprint Nextel subsidize customer purchases of the iPhone for their customers. But its lack of dividend makes it less appealing to investors than other big tech players. However, Apple's third-quarter earnings did not meet estimates -- a problem the company has not faced in years. Some argue that this may be a result of threats from Amazon.com and other competitors to Apple's iPad and iTunes businesses.

Fusion-io's data decentralization platform for data storage, which uses solid-state drives, has won clients like Apple and Facebook. The growing popularity of this platform has improved its position against competitors like EMC and NetApp. In addition, tech-powerhouses IBM, Dell, and Hewlett-Packard are helping sell Fusion-io's products. This will help Fusion-io improve its competitive advantage by diversifying its customer base and growing its overall sales.

SanDisk has made a great deal of money off the popularity of smartphones. It has had great demand for its flash memory from smartphone makers and believes the trend will only increase with the growing popularity of tablets. However, the company still has to compete with Micron Technology, which also produces flash memory. SanDisk also stands to gain from the potential changing demand from optical and magnetic storage to solid-state storage -- an area in which SanDisk and STEC lead.

Seagate fared better than some competitors in the face of the mess caused by floods in Thailand last year, which created a shortage of hard disk drives. Seagate's facilities weren't hurt as badly as Western Digital's, which gives it the opportunity to gain more market share as Western Digital struggles to recover. Seagate's ability to continue to produce and sell hard disk drives has helped it topped its sales and revenue estimates, with demand in 2012 likely to exceed supply. And unlike Apple, Fusion-io, and SanDisk, Seagate currently offers a 3.9% dividend

Hewlett-Packard has faced some struggles recently, including difficulties competing in personal computing, increasingly a low-margin business. In response, the company began to move toward offering more consulting and services in attempt to lessen its focus on a commodity business. HP also faces a challenge getting value out of its $1.2 billion purchase of Palm. It is attempting to extract that value by using its webOS operating system in its tablet, smartphone, and PCs. However, its move into the smartphone and tablet business may be too late to compete effectively with the alternatives. The company pays a modest 1.8% dividend yield.

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.