Joel Greenblatt (Trades, Portfolio) introduced the individual investing world to the "Magic Formula" when he published his 2005 book, "The Little Book That Beats the Market." The idea behind the Magic Formula is to apply a simple mathematical formula to find good businesses trading at bargain prices.
The formula ranks companies based on the combination of two metrics: earnings yield and return on capital. As the formula works best when applied to U.S. companies and companies with market caps of at least $100 million, it also eliminates companies that do not meet these criteria, as small-cap and non-U.S. businesses are often structured differently. For the same reason, utilities and financial companies are also not considered.
Below are three companies that have a GuruFocus business predictability rating of 3.5 stars or higher, demonstrate strong potential to increase their profitability and rank highly on the GuruFucus Magic Formula Screener, a Premium feature based on Greenblatt's formula.
One company that ranked highly on the Magic Formula screening was Biogen Inc. (NASDAQ:BIIB). It has an earnings yield of 12.61% (higher than 88.94% of competitors), a return on capital of 144.08% (higher than 96.53% of competitors) and a business predictability ranking of 5 out of 5 stars.
Biogen is a neuroscience pioneer based in Cambridge, Massachusetts. The biotech company researches and develops therapies for neurological and neurodegenerative diseases, including multiple sclerosis and leukemia. The science and technology that goes behind the $53 billion company's product lineup is cutting-edge, which is matched it its high prices, but consumers are willing to pay if it means relief from some of the worst diseases that humans can suffer. Below is a chart of Biogen's quarterly revenue and net income.
As of Dec. 18, Biogen has a price-earnings ratio of 10.58, a cash-debt ratio of 0.7 and an operating margin of 47.92%. According to the Peter Lynch chart, the stock is currently undervalued.
The primary reason why Biogen's share price dropped below earnings was because in March of 2018, Biogen and Eisai Co. (TSE:4523) decided to halt trials of their Alzheimer's drug, aducanumab, during phase 3 testing. After a futility analysis conducted on the drug's phase 1/1b trials, they concluded that later trials were not likely to prove the drug successful.
However, in October, data became available for the discarded phase 3 trials EMERGE and ENGAGE, which tested a total of 3,285 patients (2,066 of whom were able to complete the trial period) and which had been continuing to the end despite the company's low expectations for results.
According to analysis of phase 3 trials, patients who received a high dose of aducanumab showed an average reduction of 23% in clinical decline from the control set by the placebo group. These results saw statistically significant memory improvement among the trial group.
"This large dataset represents the first time a Phase 3 study has demonstrated that clearance of aggregated amyloid beta can reduce the clinical decline of Alzheimer's disease, providing new hope for the medical community, the patients, and their families," wrote Dr. Anton Porsteinsson, William B. and Sheila Konar (principal investigator) about the topic.
The decision to pick up aducanumab and pursue regulation for it provides hope for Alzheimer's patients, and if the drug is successfully approved, it could also translate to profits for Biogen. For once, one of Biogen's products would have the potential to be produced on a large scale, as there are 5.8 million Alzheimer's patients in the U.S. alone compared to 947,000 multiple sclerosis patients. Higher production would also drive down the cost of the drug, though pricing is still up in the air at this point.
Usana Health Sciences
Usana Health Sciences Inc. (NYSE:USNA) also ranked highly on the Magic Formula screener with an earnings yield of 10.18% (higher than 79.81% of competitors), a return on capital of 150.21% (higher than 98.11% of competitors) and a business predictability rating of 5 out of 5 stars.
This Utah-based health products company, which sells vitamins, nutritional supplements and hair and skin care products, markets itself as a cellular nutrition company. All products are meant to improve customers' quality of life through healthier, more natural body care. Usana's products are available online or through or independent distributors, but not through retail stores.
The company has seen drops in its revenue and net income since late 2017 due largely to a shrinking customer base. In the third quarter of 2018, for example, Usana reported a decline from 615,000 active customers to 558,000 active customers. The number of customers decline 6.1% in the Americas and Europe, 17.3% in Greater China and 2.6% in Southeast Asia Pacific, the only positive number being a 28.2% increase in North Asia.
Despite low sales in 2018, the company's performance began to pick back up in the third quarter of 2019, marked by a 1.7% increase in revenue and an 11.7% increase in net income. According to Chief Financial Officer Doug Hekking, "Efforts to align our cost structure with sales performance also contributed to improved sequential results."
As of Dec. 18, Usana has a market cap of $1.67 billion. From a financial standpoint, Usana is a strong company; it has no debt, a price-earnings ratio of 17.91, an operating margin of 13.8% and a three-year average share buyback ratio of 1.8. According to the Peter Lynch chart, the stock is currently trading close to its fair value.
Employee incentives and promotions have gone a long way toward building up the company's customer base again, according to CEO Kevin Guest. Usana plans to continue offering incentives through the fourth quarter of 2019, though not as vigorously as in the third quarter.
"Our firm belief is we'll get there but it is going to take some time and we're going to have to be active in playing a role and having that return to levels where we see kind of regular increases," Hekking said in the third quarter earnings call, which connects the company's profitability directly to its marketing efforts. As a company that sells its products via individual salespeople and the internet, Usana has a rather large untapped market share that depends on active customer engagement efforts. Since management's growth strategy is long term, though, these efforts may not yet translate to the kind of speedy growth that led to its overvaluation in 2018.
Another company with a high Magic Formula rating is Omnicom Group Inc. (NYSE:OMC), which has an earnings yield of 9.8% (higher than 75.79% of competitors), a return on capital of 144.18% (higher than 89.33% of competitors) and a business predictability ranking of 4 out of 5 stars.
Omnicom is a New York-based global media, corporate communications and marketing company. It provides advertising for over 5,000 clients in more than 100 countries around the world via its three global advertising agency networks and three media services providers.
Omnicom's sheer number of clients and market cap of $17.44 billion have given the communications company the income stability necessary for its earnings to show a clear cyclical pattern, with the highest revenues in the fourth quarters and the lowest in the first quarters.
The communications company has a price-earnings ratio of 13.45, a cash-debt ratio of 0.38 and an operating margin of 14.12%. Enthusiasm for Omnicom shares has waned as yearly revenue has declined somewhat, dropping from $5.41 billion in 2016 to $15.27 billion in 2017 and rising slightly to $15.29 billion in 2018.
Recent negative headwinds also included unfavorable foreign exchange rates as the U.S. dollar appreciates against many foreign currencies and the effects of making more dispositions than acquisitions over the past year. According to the website, Omnicom calculates its acquisition and disposition revenue as if it "occurred twelve months prior to the acquisition/disposition date by aggregating the comparable prior period revenue of acquisitions through the acquisition date." This keeps these changes from having a one-off effect on the numbers, but it also means that the loss of revenue streams from those dispositions has a greater effect on the company's more recent earnings.
Despite the headwinds, Omnicom is still focusing on growth. Earlier in December, one of its media companies, OMD Worldwide, made the top spot in the latest COMvergence global billings ranking report for its total projected 2019 billings of $19.6 billion. This represents a 6.1% increase in sales among an industry that has an overall growth rate of 0.6%, making it one of the fastest-growing media companies in the world.
Across the entire company, organic growth for third-quarter 2019 consisted of a 3.4% increase in Advertising compared to the prior-year quarter, as well as a 1.8% increase in CRM Consumer Experience, a 9.8% increase in Healthcare, a 1.5% decline in CRM Execution and Support and a 3.8% decline in Public Relations. Operating profit came in flat year over year. Overall, Omnicom's numbers point toward growth in the profitability of its business, but flat revenue due to factors such as dispositions and foreign exchange, causing the market to undervalue it.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful analysis or consult registered investment advisors before taking action in the stock market.
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This article first appeared on GuruFocus.