The Magic Formula for These Metals 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, 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 metals and mining fare?

Source: S&P Capital IQ.

Freeport-McMoRan Copper & Gold and Southern Copper meet both criteria. Freeport-McMoRan has an earnings yield more than double the formula's desired 10% and an ROA 3.5 percentage points above the Formula's desired 25%. Southern Copper has a 12% earnings yield and an ROA at nearly 45%. None of the other companies offer the formula's desired 25% ROA, but Barrick Gold, Newmont Mining, and Kinross Gold dp meet the formula's 10% earnings yield standard.

Molycorp, which was previously part of Chevron, mines rare-earth metals. Interest in these metals has increased after China's decision to restrict its exports of them. However, reports from Japanese researchers claim that there are 100 billion metric tons of rare-earth metals at the bottom of the Pacific Ocean. If they are able to be retrieved, this would be bad news for Molycorp and other rare-earth miners.

Taseko's growth has slowed down a great deal since late 2010, and its net margins and returns on equity have declined significantly. Taseko received some bad news in late 2010, when Canada's environment minister announced that the company would not gain regulatory approval for its Prosperity copper and gold mine. However, early last year the company discovered some niobium deposits on one of its properties. And because Taseko's Gibraltar mine has been producing some encouraging results, the company has developed plans to expand its operations at that mine.

Arcelor Mittal was struggling even before the beginning of the economic recession, showing significant declines in its earnings and free cash flow. However, the company is building up its competitive position even during these rough times. For example, it partnered with Peabody Energy in purchasing Macarthur Coal, which gives it access to a key raw material used in steel production. One thing that makes Arcelor Mittal distinct from its competitors is that it is run by Lakshmi Mittal, who still has an interest of more than 40% in the company, which means the interests of the person in charge of the business are aligned with the shareholders.

Southern Copper has some of the largest copper reserves in the world. However, because copper prices so strongly depend on infrastructure projects, slowing growth would deliver a rough blow to the company's profits. In fact, copper prices have already declined because of concerns that China's growth is slowing. In addition, while many mining companies have seen a decline in their production because of labor disputes, Southern Copper has avoided any full-on labor strikes.

Unlike most mining companies, Silver Wheaton doesn't mine its own metals. Instead, it purchases mined silver at low fixed costs by paying companies in advance. This approach allows Silver Wheaton to gain a greater benefit from increases in silver prices, and it lets the other miners get needed financing for their operations. The company also tripled its dividend since starting it in early 2011, with a current yield of 1.2%.

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.

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