The Magic Formula for Pharmaceuticals

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 and funny work 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 pharmaceuticals fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of the companies meets both standards. Forest Laboratories comes close, with an earnings yield more than twice the formula's desired 10% and an ROA within 6 percentage points of the Formula's desired 25%. Bristol-Myers Squibb also comes close, with an earnings yield above 10% and an ROA within 4 percentage points of 25%.

Drugmaker Elan gets most of its revenue from Tysabri, a drug that treats multiple sclerosis, which it sells along with Biogen Idec. However, the revenue it gets from this drug has been insufficient to make the company cash-flow positive. Most of Elan's hopes for the future lie in the success of bapineuzumab, which it's developing with Pfizer. While Johnson & Johnson also owns a 25% share of the drug, the success of bapineuzumab brings good potential for Elan's future improvement. The FDA gave the drug fast-track regulatory status. If approved, this may be the only available drug that can stop disease progression and rate decline in Alzheimer's patients.

Teva Pharmaceutical, which is mostly known for its generic drugs, has developed into a large enough company that it has a competitive advantage over smaller companies such as Mylan and Watson Pharmaceuticals. However, the low-margin nature of the generics business puts pressure on Teva to develop some of its own drugs. It has made some moves to do this by developing Copaxone, which treats multiple sclerosis, and by outbidding Valeant Pharmaceutical in its purchase of specialty pharmaceutical business Cephalon.

VIVUS has faced some setbacks with one of its more promising drugs, Qnexa, which is designed to help patients manage obesity. The FDA rejected the drug in 2010 because of concerns that although it's effective in fighting obesity, it may cause long-term side effects such as birth defects and possible effects on the heart. However, the FDA is currently reviewing the drug again, following the collection of two years of clinical data.

Avanir recently released a drug called Neudexta, which treats symptoms including uncontrollable outbursts of laughing or crying that are associated with neurological diseases. While this drug can be useful for keeping these embarrassing symptoms under control, the drug does not treat the underlying neurological diseases, among them Lou Gehrig's disease, Parkinson's disease, and multiple sclerosis, which doctors and patients are more interested in treating. For this reason, the company has had to spend a great deal of money sending sales forces on repeated visits to doctors in hopes of persuading them to prescribe Neudexta. This strategy has met with some success, with a 16% increase in Neudexta prescriptions from May to June of last year.

Depomed gained approval in January of last year for its Gralise drug, which treats the pain patients get after getting shingles. The approval resulted in a 30% increase in Depomed's shares a few days after the news. Early on, the company faced some setbacks when Abbott Labs announced that it didn't plan to release Gralise. However, in March, Depomed ended a licensing agreement with Abbot, which gives it all of the profits arising from Gralise. Shares started to rise in late December, as the company has seen encouraging early sales and JMP Securities gave Depomed a "Market Outperform" rating.

Foolish bottom line
The key advantage of the Magic Formula is speedy decision-making. You can run a screen and 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.

Although 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.

With high-risk propositions on sometimes unproven drugs, investing in pharmaceuticals is not for everyone. And that's OK. If you'd like to invest in lower-risk companies with more certainty of success, check out our special free report: "3 American Companies Set to Dominate the World." It's available free for a limited time. Get your copy.