Michael Santoli

'Magic Formula' finds cheap, high-quality stocks in the Buffett style

Michael Santoli
Wall Street sign
.

View photo

Wall Street sign

Maybe the best thing about the Magic Formula stock-picking method is that there’s no magic to it at all.

Devised and popularized by Joel Greenblatt  a devotee of the Ben Graham/Warren Buffett school of value investing and a top-performing hedge fund manager since the 1980s - the Magic Formula uses two financial measures to find high-quality companies trading at attractive prices.

In market environments such as the one we’re in now – with the indexes trading at above-average valuations, profit growth getting scarcer and investors lacking conviction – screening for stocks using this formula can help identify pockets of value that are going largely unnoticed.

Greenblatt, founder of Gotham Capital, popularized his approach in “The Little Book That Beats the Market” in 2005, and anyone can register to use www.magicformulainvesting.com to screen for stocks that meet the Magic Formula criteria.

The formula seeks attractively priced stocks with a high “earnings yield,” or strong reported profits compared to the companies' market value. To get at core profitability, Greenblatt prefers tracking earnings before taxes and interest, and adds net debt to stock-market value to arrive at “enterprise value.” Then, to measure the quality of the business, only companies with a strong return on capital are included.

This is roughly the way a private business would be evaluated. When a stock scores highly enough on both fronts, it usually means a good company is temporarily being viewed skeptically by investors. Sometimes this is for good reason and the stocks suffer for a while. The process tends to surface a decent sampling of controversial names, some of which are viewed as having major threats to their profit stream.

Taken as a group, though, Magic Formula names have vastly outperformed the broad market over time, and Greenblatt’s work advises investors to buy an assortment of the stocks, hold them for a year, then sell those that no longer qualify and perform a new screen to replace them.

The system is a way to stick to the sort of contrarian discipline that has helped nervy value seekers, such as Buffett, take advantage of Mr. Market’s emotional swings. Of course, Buffett's investment skills and advantages can't be captured or simulated in a mathematical formula. He has tens of billions of dollars to work with and huge embedded profits in his blue-chip stock holdings bought cheap decades ago. The Omaha sage is often offered a "first look" at companies to acquire or invest in on sweetheart terms.

Still, even if one can't use this tool to fill up a basket with Buffett stocks, screening the available universe of equities using the Magic Formula can cast some light on some areas of opportunity. The selection of stocks highlighted by the formula changes a bit daily with market prices, but here are some investable themes evident from screening all stocks of at least $500 million in market value over the past two days.

Putting up a strong defense

Military-contractor shares have been an excellent performer over the past couple of years, though the iShares US Aerospace & Defense fund (ITA) has gone flat since January. The Magic Formula is still identifying some big defense players as attractive, with Northrop Grumman Corp. (NOC), General Dynamics Corp. (GD) and Raytheon Co. (RTN) all appearing there this week.

While entirely a different weapons business, it so happens the two big publicly traded firearms companies – Smith & Wesson Holding Corp. (SWHC) and Sturm Ruger & Co. (RGR come up on the screen, too.

Game on

The videogame subsector is always hopping, with hit-driven game makers, cult-favorite stocks and huge concerns about the shift to online games animating it. Right now, a smattering of the prominent names are showing up as attractive, including Take-Two Interactive Software Inc. (TTWO), Activision Blizzard Inc. (ATVI), GameStop Corp. (GME) and even the recent busted IPO King Digital Entertainment plc (KING) – maker of Candy Crush mobile apps.

Your father’s tech stocks

There has always been a line of thought that, when big tech stocks look fundamentally “cheap,” they present a potential value trap. The high cash flows come from old installed-base products rather than hot new ones, and legacy giants are often viewed as too big to innovate well.

Nonetheless, the Old Tech theme has produced its share of winners in the past couple of years. The Magic Formula continues to fix on some of the last generation’s Nasdaq favorites, including Cisco Systems Inc. (CSCO), CA Inc. (CA), Microsoft Corp. (MSFT), Hewlett-Packard Co. (HPQ) and – yes – Apple Inc. (AAPL), an Old Tech name that doesn’t fully act its age.

The media is the message

While hardly laggards, some big media companies qualify for their combination of strong cash earnings and decent valuations. This week Time Warner Inc. (TWX), Viacom Inc. (VIA), Omnicom Group (OMC) and Starz (STRZA) made appearances.

The Hatfield-McCoy stocks

The system locks in on plenty of divisive companies that investors like to feud over. They're loved by some as nice growth businesses at the same time they’re targeted by shorts sellers, either for doubts about the durability of their profits or concerns about business practices and regulatory attention.

The “multi-level marketing” guys are here, with Herbalife Ltd. (HLF) and Nu Skin Enterprises Inc. (NUS). And most of the larger for-profit education firms also fall into this bucket, such as Apollo Education Group (APOL), ITT Educational Services Inc. (ESI) and Capella Education Co. (CPLA). Anyone tempted to play here should recognize there’s plenty of “headline risk” to such stocks.

The former prom queens

“Fallen consumer growth” is almost an investment category in itself, full of once-beloved companies that seemed to gobble up market share at will in their prime, but have faltered and been punished by investors for the sin of no longer being so young any more.

Coach Inc. (COH), down from $70 to $44 in two years as fresher competitors in fashion accessories have eclipsed its brand, is on the list, a sign that this once-super-expensive name has become value-investor prey. Francesca’s Holdings Corp. (FRAN), a clothing and accessories retailer, has flopped badly and is now a “show me” story for investors. Meantime, from a prior generation of growth retailing, Gap. Inc. (GPS) ducked into the screen after its shares shed 15% of their value since last summer’s high  not a bad representation of the kind of quality goods on sale that the Magic Formula is meant to find.

Rates

View Comments (10)