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 pre-tax 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. Greenblatt looks for companies with an ROA higher than 25%.
So how do some of the biggest companies in machinery fare?
Illinois Tool Works
Stanley Black & Decker
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards. Parker Hannifin offers the Formula's desired 10% earnings yield, and Illinois Tool Works and Cummins come close, but none of the companies offers a 25% ROA. Cummins also has the highest ROA at 18%.
Manitowoc (NYS: MTW) makes cranes for industrial construction projects and produces equipment for food service providers. Its involvement in the food business has helped it weather the storm of the recession, which has hit the construction business particularly hard. Its food business has allowed the company to enter into emerging markets through clients like McDonald's and Yum! Brands, which use some of its food service equipment. Its involvement in the construction industry should also benefit from entrance into emerging markets.
Westport Innovations (NAS: WPRT) makes natural gas engines. While the current low prices of natural gas are good news for the company, the lack of infrastructure to support natural gas-powered vehicles limits that advantage. However, the company has benefited from deals with big companies like Ford (NYS: F) to produce natural gas engines for its F-250 and F-350 pickups, and General Motors, which gives it the opportunity to set the standard for advancements in natural gas capabilities among companies that are worried about falling behind one another. It has also partnered with Caterpillar (NYS: CAT) to incorporate natural gas technology into its equipment, which gives Westport exposure to the emerging markets Caterpillar is involved in.
Cummins also creates engines, but its business model differs from Westport's in that all its business comes from partnerships with other companies, which incorporate Cummins' engines into their machines, giving it even more exposure to emerging markets.
As a farm equipment maker, Deere (NYS: DE) has benefited from rising food prices and an increase in demand for farm equipment in emerging markets. However, reliance on the notoriously volatile farming industry may spell trouble for the company if crop prices go back down.
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.
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At the time thisarticle was published Jim Royal, Ph.D., owns shares of McDonald's.The Motley Fool owns shares of Yum! Brands and Ford Motor.Motley Fool newsletter serviceshave recommended buying shares of Yum! Brands, General Motors, Cummins, Westport Innovations, Ford Motor, Illinois Tool Works, McDonald's, and PACCAR.Motley Fool newsletter serviceshave recommended creating a synthetic long position in Ford Motor. 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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