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 household durables fare?
Enterprise Value (in Millions)
EBIT (in Millions)
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but Tempur-Pedic comes close, with an earnings yield nearly 15 percentage points higher than the formula's desired 25% ROA, and an earnings yield less than 3 percentage points from the formula's desired 10%.
SodaStream (Nasdaq: SODA ) creates products that individuals can use to carbonate water at home. The company uses a business model similar to that employed by Green Mountain Coffee Roasters, which sells consumers its coffee maker and the K-Cups the machine uses. Similarly, SodaStream sells customers the soda machines and consumable products such as syrups and carbon dioxide canisters. It is working to promote its sales by selling its products at a wide variety of retail stores, including Bed Bath & Beyond, Williams-Sonoma, Best Buy, and Target.
Whirlpool's (NYSE: WHR ) sales have suffered from a struggling economy. However, as the largest major appliance company in the world, it stands to gain from increasing disposable income in emerging markets. In fact, it has already moved to take advantage of these markets by extending its business into Latin America. Its size also helps it compete effectively even with other leading brands like Sears Holdings by taking advantage of economies of scale to spread out its expenses, negotiate better prices, and create effective advertising.
PulteGroup (NYSE: PHM ) , a homebuilder, has suffered a great deal from the struggling housing market. The company has failed to make a profit after 2006, and its revenues in 2011 were less than half of its 2005 revenues. Also, while the housing market has been showing some signs of recovery, Pulte has not been showing the increases in orders seen by peers Standard Pacific and Beazer Homes.
Gafisa (NYSE: GFA ) , a Brazilian homebuilder, has seen its stock price drop by more than half in the past year, likely due to recent increases in interest rates in Brazil. Also, there are some concerns that the Brazilian economy may be overheating, which may have scared off some investors.
ZAGG (Nasdaq: ZAG ) , which produces mobile accessories, benefits from the popularity of smartphones. However, its strong dependence on Best Buy, which accounts for 40% of its sales, is worrisome. A decision from Best Buy to dedicate less shelf space to ZAGG's products would likely have a major effect on the company's bottom line. Also, with companies like Apple working to sell more of its products on the Web and at its own retail stores, ZAGG will have fewer opportunities to sell its products unless it can expand its reach.
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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