The Magic Formula for Communications

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 the communications equipment sector fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of the companies meets both standards, but ADTRAN comes close, with an earnings yield above the Formula's desired 10% and an ROA within 1 percentage point of the Formula's desired 25%. The only other company that offers the Formula's desired 10% earnings yield is InterDigital, and its 15% ROA is above what is offered by most of its industry peers.

InterDigital patents wireless technology that big industry players such as Apple and Research In Motion use in their products, including their popular smart phones. Its shares rocketed last July as a result of speculation about the value of its intellectual property, but prices have steadily declined ever since.

JDS Uniphase has suffered along with other businesses in the optical-networking market last year after Finisar's shares went down in March and spooked investors holding shares of peers like JDS, Oclaro, and Oplink. Shortly afterwards, JDS reported strong earnings, but its share price has never recovered. However, since then JDS's earnings have once again declined and don't show signs of much improvement in the near-term.

Brocade is a storage-networking specialist that looked like it was well-positioned to benefit from the struggles of some of its competitors last year, when Cisco lost big clients IBM and Hewlett-Packard. Unfortunately for Brocade, it was unable to claim all that business, as HP has been decreasing its hardware business. In addition, earlier rumors of a buyout from HP, IBM, or Oracle have all but disappeared. However, hope for improvement lies a cloud-based-computing initiative with partners EMC and VMware.

Juniper Networks has attempted to distinguish itself from Cisco, Brocade, and others by putting a huge portion of its revenue into research and development. While this strategy may promote innovation, it also decreases earnings. And in response to a struggling economy, AT&T and Verizon spent less on networking equipment than usual in the second half of 2011, which resulted in a drastic drop in Juniper's share prices, followed by a fairly steady decline into the present.

Ciena posted strong third-quarter results, with growth in most of its segments and lower expenses. The network and optical equipment provider also reported an adjusted net income of $0.08 per share, which exceeded expectations of negative $0.08 per share. It also gained some clients, with 10% customer growth bringing in 17% additional revenue. Ciena's fourth-quarter results were not as strong, however, with reported overall losses despite rising revenues. It also has a huge pile of debt to service.

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 shares of AT&T. The Motley Fool owns shares of IBM, Apple, EMC, and Cisco Systems and has created a bull call spread position on Cisco Systems.Motley Fool newsletter serviceshave recommended buying shares of InterDigital, Cisco Systems, VMware, Apple, and Acme Packet and creating a bull call spread position in Apple. 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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