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 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 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 Rambus
|
Company |
Enterprise Value |
EBIT |
Earnings Yield |
ROA |
|---|---|---|---|---|
| Rambus | $492 | $73 | 14.9% | 10.6% |
| NVIDIA | $5,917 | $669 | 11.3% | 12% |
|
Micron Technology |
$9,161 | ($102) | (1.1%) | (0.7%) |
|
Cree |
$2,729 | $73 | 2.7% | 2.7% |
|
RF Micro Devices |
$1,127 | $50 | 4.4% | 5% |
| Intel | $132,116 | $17,477 | 13.2% | 24.6% |
| Texas Instruments | $39,386 | $3,530 | 9% | 17.2% |
| Broadcom | $17,126 | $910 | 5.3% | 10.1% |
| Applied Materials | $15,523 | $1,980 | 12.8% | 14.6% |
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets the standard. However, Intel comes close, with an earnings yield more than 3 percentage points above the Formula's desired 10%, and an ROA less than a half a percentage point away from the Formula's desired 25%. Rambus, NVIDIA, Intel, and Applied Materials all meet the Formula's desired 10% earnings yield, but none of the companies meets the Formula's desired 25% ROA.
Semiconductor maker Rambus develops and licenses standards for memory chips. In mid-2011, the company scored a victory when General Electric announced its decision to use Rambus' technology in its line of LED lighting fixtures. But despite Rambus' success in its core business, the company has suffered from legal drama surrounding its attempts to gain compensation for alleged patent infringements. It filed suits against many companies, including NVIDIA, Broadcom, LSI, and Freescale Semiconductor. While the company has gained some success with these lawsuits, it faced a major setback earlier this year when the U.S. Patent and Trademark Office invalidated patents that Rambus considered among its most valuable intellectual property. These patents describe DDR-SDRAM memory chip technology used in personal computers.
NVIDIA has benefited a great deal from the increasing popularity of mobile devices, with its quad-core Tegra 3 chip mobile processor offering strong performance and long battery life. However, the company faced a setback when Intel developed new processors that integrate graphics, making them less reliant on NVIDIA's graphics processor units.
Memory-chip maker Micron Technology is facing challenges associated with price wars with competitors such as SanDisk. Micron's sales have suffered because two of the company's major customers -- Nokia and Research In Motion -- have been also struggling lately. However, the company scored a victory late last year when it won a victory in its lawsuit against Rambus that granted Micron up to $12 billion in damages.
Cree is the leading company in producing light-emitting diode technology. The company recently partnered with General Electric to produce LED bulbs. However, Cree faces competition from a number of companies in the area of LED lighting. For example, Cirrus Logic is looking to expand beyond its core sound-processor chip business to make power-management modules for use in LED lighting systems. Universal Display offers organic LED technology, and Veeco Instruments offers equipment used to manufacture LEDs, which offers Chinese companies greater flexibility in adopting LED lighting. Partially as a result of such competition, Cree also faces challenges related to falling prices in the industry because of an oversupply of LED products.
RF Micro Devices manufactures radio chips that are used in mobile communication devices. While you might expect RF to benefit a great deal from the popularity of smartphones and tablets, the company hasn't managed to gain business from a large portion of key smartphone and tablet makers. RF's clients include Research In Motion and Motorola, among others, but its clients are not numerous or big enough to put RF in a position to compete with its industry peers. RF currently depends on the Chinese cellular market, which is suffering from weak demand, for a third of its revenue.
Foolish bottom line
The key advantage of the Magic Formula is speedy decision-making. You can run a screen, mechanically buy the stocks, and 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.
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