The Magic Formula for These Energy Companies

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 and funny work 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 (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 energy fare?

Source: S&P Capital IQ.

None of these companies meets both Magic Formula criteria. CNOOC has the highest ROA and is within 1 percentage point of offering the formula's desired 25%. Zebra Technologies also comes close, with an ROA within 4 percentage points of the 25% threshold. Five companies -- SandRidge Energy, CNOOC, Peabody, Suncor, and Apache -- meet the Formula's 10% earnings yield threshold, and Zebra Technologies is close.

SandRidge Energy has shown some strong revenue growth in the past year, but it still has a lot of debt and may face challenges in the future as oil prices decline. While it started as a natural gas company, SandRidge has shifted its focus to oil drilling because of the difficult market in natural gas over the past few years. It's now the third-largest oil rig operator, after Chesapeake and EOG Resources. However, because SandRidge's free cash flow hasn't kept up with its drilling operations spending, it has had to spin off SandRidge Mississippian Trust (NYSE: SDT) and SandRidge Permian Trust, two trusts that offer whopper dividends.

Chesapeake has also faced challenges posed by the struggling natural gas market and, like SandRidge, has put a greater emphasis on oil and other liquid fuels. This move has already helped the company, and its cooperation with CNOOC to drill the Eagle Ford holds some promise for growth.

Canadian energy company Suncor has benefited from the fact that the U.S. gets a great deal of oil from Canada, especially Alberta's oil sands. To milk this advantage, Suncor has established a joint venture with Nexen, Imperial Oil and several other companies to use oil sands to produce synthetic crude. It also partnered with Total to pool their interests in the Fort Hills, Voyageur, and Joslyn projects.

Rentech (AMEX: RTK) is involved in both the biofuel and the nitrogen fertilizer industries, both of which have been facing favorable market conditions. Because of high crop prices in 2011, people are anticipating an increase in planting in 2012, which is good for Rentech's fertilizer business. In the biofuel business, Rentech faces the advantage that it can make its biofuel products from multiple inputs, including biomass and waste streams, instead of being limited to using the plant-based sugars that companies such as Amyris use. It also can use its fertilizer business as a source of capital to fund the development of its biofuel business.

Frontline (NYSE: FRO) has had to deal with extremely challenging market conditions in the oil-tanker industry, including a decrease in oil production in Africa and the Middle East, an oversupply of ships, and falling demand. In fact, rates went so low that Frontline stopped taking on cargo last summer.

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.

Although 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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