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, or 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 aerospace and defense fare?
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but six of them exceed our desired 10% earnings yield and most offer nearly half of our desired 25% ROA. You can see investors' concerns over defense spending resulting in the high earnings yields here.
United Technologies is best known for its aerospace and defense businesses, but it also branches out into other industries by offering HVAC equipment and fire safety systems. The business has also worked to extend its exposure further into the civilian aerospace market by making a $16.5 billion dollar deal to buy Goodrich.
Major defense companies like Lockheed Martin and Raytheon have suffered from falling share prices due to concerns about budget cuts in defense. Boeing and General Dynamics have responded to these budget concerns by selling their products at a discounted rate.
While shareholders have bid down the price of these companies due to worries about budget cuts, this may present investors with the opportunity to buy these companies on sale. However, there are some reasons to believe these fears are overblown, and that the government will still be throwing a lot of money into the defense sector.
Finally, several of these companies offer a nice dividend yield, with United Technologies and Boeing offering a 2.5% dividend yield and Lockheed Martin offering a whopping 5.1% dividend yield.
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.
Interested in adding any of these companies to our Watchlist? Click on the links below:
- Add United Technologies to My Watchlist.
- Add Raytheon to My Watchlist.
- Add Precision Castparts to My Watchlist.
- Add Northrop Grumman to My Watchlist.
- Add Lockheed Martin to My Watchlist.
- Add Honeywell International to My Watchlist.
- Add Goodrich to My Watchlist.
- Add General Dynamics to My Watchlist.
- Add Rockwell Collins to My Watchlist.
- Add Boeing to My Watchlist.
Jim Royal, Ph.D., does not own shares of any company mentioned. The Motley Fool owns shares of Lockheed Martin, General Dynamics, Raytheon, and Northrop Grumman. Motley Fool newsletter services have recommended buying shares of Precision Castparts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.