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 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.
So how do Reynolds American (NYS: RAI) and a few peers fare?
Lorillard (NYS: LO)
Altria Group (NYS: MO)
Philip Morris International (NYS: PM)
Source: S&P Capital IQ.
Going by the Magic Formula criteria, only Lorillard meets both standards, with an 11.5% earnings yield and a whopping 42.6% ROA. Philip Morris International also comes close, falling just half of a percentage point shy of offering the Formula's desired 10% earnings yield and just 3 percentage points shy of offering its desired 25% ROA. Reynolds American also offers the Formula's desired 10% earnings yield, but its ROA is just 9.8% and the lowest of the listed companies.
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 your Watchlist? Click on the links below:
Add Reynolds American to My Watchlist.
Add Philip Morris International to My Watchlist.
Add Altria Group to My Watchlist.
Add Lorillard to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns shares of Philip Morris.The Motley Fool owns shares of Altria Group and Philip Morris.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris International.Motley Fool newsletter serviceshave recommended creating a bear put ladder position in Lorillard. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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