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 auto components fare?
TRW Automotive Holdings
Goodyear Tire & Rubber
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but five of them exceed our desired 10% earnings yield and four offer ROAs above 12%.
Autoliv offers fairly strong numbers in both categories, with an earnings yield above 18% and a 15.5% ROA. The company has cornered its niche market by making seatbelts and airbags for customers like Ford, General Motors, and several foreign automakers.
Autoliv's main competition comes from TRW Automotive, which also makes seatbelts and airbags, along with other auto parts. While TRW does not have the same range of customers, it has better returns on equity and a cheaper valuation. However, Autoliv offers a 3.3% dividend yield, while TRW does not offer a dividend at all.
Despite Autoliv's market advantage, its share prices have fallen dramatically due to cash flow problems and slowing operating results coming from ongoing antitrust investigations and the European financial crisis.
Goodyear went through tough times during the recession, as decreased car sales hurt tire sales. In July, however, the company reported a huge increase in revenue despite lower sales. While this is good news, Goodyear also reported likely future increases in its expenses due to a rise in costs of raw materials.
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 Visteon to My Watchlist.
- Add TRW Automotive Holdings to My Watchlist.
- Add Magna International to My Watchlist.
- Add Lear to My Watchlist.
- Add Johnson Controls to My Watchlist.
- Add Goodyear Tire & Rubber to My Watchlist.
- Add Gentex to My Watchlist.
- Add BorgWarner to My Watchlist.
- Add Autoliv to My Watchlist.
Jim Royal, Ph.D., does not own shares of any company mentioned. The Motley Fool owns shares of Ford Motor. Motley Fool newsletter services have recommended buying shares of Autoliv, Ford Motor, BorgWarner, and General Motors; and creating a bear put ladder position in Autoliv. 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.