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 the media fare?
|
Company
|
Enterprise Value (in Millions)
|
EBIT (in Millions)
|
Earnings Yield
|
ROA
|
| SIRIUS XM Radio |
$10,464 |
$676 |
6.5% |
9% |
| Sinclair Broadcast Group |
$2,178 |
$226 |
10.4% |
14.4% |
| Interpublic Group |
$5,425 |
$635 |
11.7% |
5.4% |
| IMAX |
$1,426 |
$20 |
1.4% |
5.5% |
| World Wrestling Entertainment |
$565 |
$65 |
11.4% |
16.8% |
| Comcast |
$129,422 |
$10,028 |
7.7% |
6.4% |
| News Corp. |
$55,242 |
$5,422 |
9.8% |
9% |
| Time Warner |
$52,775 |
$5,955 |
11.3% |
8.8% |
| DIRECTV |
$44,536 |
$4,453 |
10% |
24.4% |
| Time Warner Cable |
$45,632 |
$4,199 |
9.2% |
8.7% |
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but DIRECTV comes close, with an earnings yield meeting the formula's 10% standard, and an ROA less than 1 percentage point away from the formula's desired 25%. None of the other companies comes close to meeting the formula's desired 25% ROA, but Sinclair Broadcast Group, Interpublic Group, World Wrestling Entertainment, and Time Warner Cable all offer the formula's desired 10% earnings yield.
Sirius XM Radio (Nasdaq: SIRI ) performed well in 2011, with 12% gains in its stock price when the average share price remained relatively flat for most companies. While the company does not have competition from conventional radio stations, it faces challenges from other companies like Pandora, which allows individuals to access streaming radio through their smartphones and wireless Internet. Also, Ford and Toyota are making cars that allow consumers to listen to streaming music through Bluetooth technology. Both allow individuals an alternative to traditional radio when they wish to listen to music in their cars.
At the end of last year, TV broadcaster Sinclair Broadcasting Group (Nasdaq: SBGI ) announced that it was raising $555 million to acquire Four Points Media and some assets held by Freedom Communications. These acquisitions represent a major expansion for this relatively small company by giving it 15 new stations in areas like West Palm Beach, Albany, and several cities in the Midwest. However, it does increase the company's already large debt load.
International advertising conglomerate Interpublic Group (NYSE: IPG ) has taken two big hits in the last decade. First, the dot-com bust brought the company into a money-losing cycle that continued long after most companies recovered. Just as Interpublic began to recover, it was hit again by the current recession. Now that some of its major clients in the automotive and financial services industry are starting to recover, Interpublic shows some hope of recovery as well.
While IMAX (NYSE: IMAX ) was previously associated with museums and other non-traditional theaters, it has successfully positioned itself as an integral part of the distribution strategy for major films. An important step was its work in developing technology that allowed IMAX screens to be installed in traditional theater spaces. As a result, the portion of box office revenue from IMAX viewings is growing over time.
World Wrestling Entertainment's (NYSE: WWE ) access to revenue has declined with the struggling economy and a decreased willingness of individuals to spend money on entertainment. However, WWE has responded with cost cuts that have allowed it to keep its net income up. It is also working to increase the value of its brand by striking licensing deals with toymaker Mattel and video game maker THQ, which bring in a steady stream of income.
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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