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 electrical equipment, instruments, & components fare?
Enterprise Value (in Millions)
EBIT (in Millions)
Source: S&P Capital IQ.
Going by the Magic Formula criteria, none of these companies meets both standards, but Dolby Labs (NYS: DLB) comes close, with an earnings yield far above the formula's desired 10%, and only 3 percentage points below the formula's desired 25%.
Corning (NYS: GLW) sells LCD displays to major companies like LG Display and AU Optronics. It also sells gorilla glass, which is scratch-resistant, to smartphone makers like Apple and Motorola Mobility. The stock has declined recently due to reports that future growth would slow down because of shrinking demand for LCD TVs. However, the shrinking stock price gives investors the chance to cash in on a better dividend yield, which is currently at 2.1%, for a company known for innovation. If the company is able to create more products that create such strong demand, the stock price will be well poised to grow.
Universal Display (NAS: PANL) produces organic light-emitting diodes, or OLEDs, which are used to create the light needed for televisions, computer screens, and smartphone displays. Samsung and LG Display both have licensing agreements with Universal Display. But with other companies using OLED technology, including Motorola Mobility, Nokia, and Dell, Universal Display still has the chance to expand its reach in the OLED market.
Dolby Labs is the dominant player in audio entertainment technology, providing sound equipment for software, consumer electronics, and movie theaters. One of Dolby's main sources of revenue is providing sound technology for games. Its clients in this area include Microsoft, Sony, and Electronic Arts. Dolby also makes money from its licensing agreements with laptop makers, but its overall margins would benefit if the company could extend its reach into the tablet market.
TTM Technologies (NAS: TTMI) makes circuit boards. It has nearly doubled its size from its gradual acquisition of Asian board maker Meadville, which was announced in 2009. The company has benefited from exposure to the popular smartphone and tablet markets through Apple.
Itron (NAS: ITRI) produces smart meters used to measure consumption of water, electricity, and gas. Its shares have declined by more than 33% since last year. However, the company may be able to increase its revenues over the next year due to cost cutting from its gradual closing of several of its plants. The company claims that this will allow it to save around $30 million per year starting in 2013.
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 Microsoft.The Motley Fool owns shares of Apple, Corning, and Microsoft.Motley Fool newsletter serviceshave recommended buying shares of Dell, Universal Display, Microsoft, TTM Technologies, Corning, Apple, and Dolby Laboratories.Motley Fool newsletter serviceshave recommended creating a covered strangle position in TTM Technologies, creating a bull call spread position in Microsoft, 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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