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 (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 leisure equipment and products fare?
Sturm, Ruger & Co.
Steinway Musical Instruments
Source: S&P's Capital IQ.
Going by the Magic Formula's criteria, none of these companies meets both standards, but Sturm, Ruger, & Co. and Polaris come close. Both exceed the Formula's desired 25% ROA, and both are within 2% of the Formula's desired earnings yield.
Eastman Kodak's (OTC: EKDKQ) name was previously dominant in cameras and film, but it has failed to innovate in ways that have allowed it to remain successful in a market that favors digital cameras. Since 2007, the stock price has declined from more than $25 per share to less than $1 per share. In October, the company announced its plans to explore strategic alternatives in advance of selling the company, breaking it up, or filing for bankruptcy. Kodak's major value comes from digital technology patents and licensing agreements with IMAX that allow it to use Kodak's laser projection patents. It also has some pending lawsuits against Apple and Research In Motion that has the potential to pay out $1 billion in royalty payments. Unfortunately for Kodak, these benefits may not be enough to save the struggling company.
LeapFrog's (NYS: LF) shares have more than doubled since their August low. The company generated a lot of excitement over its children's tablets, which sold online for nearly twice their suggested retail price after stores began to run out of them. There are several things that distinguish it from more traditional tablets, including security settings that allow parents to control the content, a lack of Web searching capabilities, and limited storage. However, these differences make the tablet more appealing to parents while taking advantage of the growing popularity of tablets in its marketing of the product.
While gun maker Sturm, Ruger's (NYS: RGR) sales were initially hit hard by the economic recession, sales bounced back in 2008 due to concerns about new gun-control laws from the Obama administration. The company stands to gain more benefit from the decision of Wal-Mart to resume its sale of firearms in some of its stores, which should help add to the demand for Sturm's products. Also, with recently-updated concealed gun laws in several states, Sturm may have a competitive advantage over Smith & Wesson due to the high popularity of its LCP .380 compact handgun.
Polaris Industries' (NYS: PII) shares have increased by over 60% from last year. The company produces a wide variety of recreational vehicles, including motorcycles, all-terrain vehicles, and snowmobiles. One might assume that such purchases would slow down during a recession, but innovation has allowed the company to exceed analyst estimates over the past year and a half. In addition to developing popular new all-terrain products, Polaris has streamlined its re-ordering system, which has increased its profit margin.
Callaway Golf (NYS: ELY) has suffered from the economic downturn even more than other athletic businesses, likely because of the high price of playing the sport as compared with other athletic activities.
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, then 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., does not own shares of any company mentioned. The Motley Fool owns shares of Apple and Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying shares of IMAX, Wal-Mart Stores, Hasbro, and Apple; creating a diagonal call position in Wal-Mart Stores; and creating a bull call spread position in Apple. 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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