The Magic Formula for Chemicals

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 chemicals fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of these companies meets both standards, but PotashCorp comes close, with an earnings yield less than 1 percentage point away from the Formula's desired 10%, and an ROA just over 1 percentage point away from the Formula's desired 25%. LyondellBasell also stands out by offering more than double the Formula's desired 10% earnings yield.

PotashCorp has grown its revenue over 50% since 2010, which puts its five-year average revenue growth rate above 20%. Two major causes for this increase include PotashCorp's ability to sell its products in emerging markets, and the major increase in crop prices, which has given farmers more money to spend on fertilizers and farming equipment. Mosaic has benefited from similar tailwinds, with high fertilizer prices driving its expansion.

While Monsanto's seed business has also improved because of the increase in crop prices, its profits have suffered a great deal because of generic competition for its Roundup herbicide, which had previously brought in much revenue. The company also faces challenges into the future because of attacks on its corn by Western corn rootworms it had been designed to resist, which opens it to competition from companies that can solve the issue.

Sherwin-Williams has seen some nice revenue growth over the past year, at nearly 15%. However, it has recently slowed its dividend growth and currently offers only a 1.6% yield. The company also faces several challenges found in the construction industry right now, including decreased spending in building and renovation and increased costs in commodities needed for its products. And because its margins are already so low, Sherwin-Williams lacks the ability to absorb those price increases, so its resilience relies on the company finding a way to pass on those expenses to consumers.

Dow Chemical has also seen some nice revenue growth over the past year, at nearly 14%. It also has a five-year average dividend growth rate of nearly over 11% and offers a current yield of 3.4%. Like other chemical companies, Dow is benefiting from higher prices, even as sales volume remains fairly constant.

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.

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At the time thisarticle was published Jim Royal, Ph.D., owns no shares of any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Sherwin-Williams and Chemical & Mining of Chile and creating a synthetic long position in Monsanto. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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