The Magic Formula for Internet Software

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 Internet software and services sector fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, no company meets both standards, but Baidu scores an ROA 5 percentage points above the Formula's desired number, beating out even the vaunted Google. The only other company that meets the Formula's desired 25% earnings yield is Sohu.com.

Google is a known master of innovation, and events from the past year show that the company plans on continuing that pattern rather than resting on its laurels. Google continues to dominate its core search-engine business and is constantly trying to find new ways to extend its success into other areas. For example, it recently developed an open-source Android operating system that controls more than 40% of the smartphone market in the United States. In August, it also announced the purchase of Motorola Mobility.

Baidu dominates the Internet search-engine business in China, managing more than three-quarters of the search queries in the country. It has also maintained strong growth, with the third quarter showing a five-year average revenue growth rate above 80%. Despite challenges from recent Chinese start-ups, Baidu has entered into the niche markets they created, extending its competitive advantage despite those threats. However, Baidu has also faced accusations of fraudulent search clicks and the corresponding claim that this prevents advertisers from getting what they paid for. Baidu's continued growth will depend on its ability to respond effectively to these accusations.

Sina's Weibo service, which some view as the Chinese version of Twitter, may provide several high-growth opportunities for the company. For starters, Weibo reported about 233 million registered users in August, which is far above the number of users for Twitter, Renren, or LinkedIn. There are also reports that SINA is considering an extension into the U.S. market. However, SINA will have to deal with challenges from Facebook and Baidu, which are discussing a partnership to create a version of Facebook designed specifically for China.

Renren's stock has tanked since its IPO, declining from its starting price of $24 per share to its current price of $3.30. The company produced $700,000 in profits in its second quarter, but it has been losing money ever since. While Renren has not had any problem growing its revenue, it has consistently failed to keep its costs low, with operating costs above 90% in its third quarter. Renren has also had to spend a significant amount of money to keep its growth rate up and defend its competitive advantage in China against Google's Google +, Facebook, and News Corp.'s MySpace, and as of yet it's unclear whether Renren will be able to maintain its supremacy.

Akamai has had a rough year, with losses of about 33% in its stock price over the year. While perhaps the growing amount of content hosted on the Internet should have increased the demand for Akamai's technology, the company faced a strong setback when Netflix started working with Limelight Networks and Level 3 Communications to provide its streaming content instead of continuing to rely on Akamai as its sole provider. It has also faced competition from EdgeCast, which currently powers AT&T's content delivery network, and Cotendo, which collaborated with Google on an open-source application acceleration, to which Akamai responded with a patent-infringement lawsuit.

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.

The success of many tech companies is linked with the growing popularity of tablets and iPhones. If you'd like to learn more about how you can cash in on this booming market, check out our special free report, "3 Hidden Winners of the iPhone, iPad, and Android Revolution." It's available free for a limited time. Get your copy.