Like Value Stocks? Stick With This "Magic Formula" King

Like Value Stocks? Stick With This "Magic Formula" King

I've written, time and again, that I feel Joel Greenblatt's "magic formula" is a great tool for individual value investors.

The formula aims to find cheap stocks that are performing well, by seeking out stocks with the best combination of low prices compared to earnings, along with high returns on capital. While that sounds overly simple, following this simple formula would've helped you trounce the market over many years.

This formula, and Greenblatt's philosophy, have me feeling like Coach may be a value today.

Coach: The Magic Formula king
Accessory and apparel giant, Coach , has taken shareholders for a wild ride over the past year. Increased competition, from companies like Michael Kors and Vera Bradley , along with management changes, have cast a shadow over this handbag king.

Just how fast has Michael Kors been closing in on Coach? Fast.

Kors most recent quarter beat already high, earnings estimates by 25%, as same-store sales grew a staggering 27%. Kors is also expected to grow earnings at a rate of 40% this year, considering it's beaten quarterly expectations every quarter since going public, the good times may just keep rolling for Kors.

Perhaps more frightening is the competition from businesses like Vera Bradley. This company sells handbags, accessories, and other goods that compete in Coach's women's market, at a much cheaper price. Vera Bradley has grown revenue in excess of 14% annually, since it went public.

Coach is experiencing heavy competition from both luxury competitors, as well as the discount ones. This doesn't, however, spell doom for Coach.

With a P/E around 15 and returns on capital of 31.17%, vs. an industry average of 10, Coach is a magic formula king. This matters because the "magic formula," while sounding silly, relies on numbers and not opinions. By buying "magic formula" stocks, you will increase the likelihood that you're investing in good companies that are cheap, and not just cheap companies.

If you take the "noise" away, Coach is a business with a great track record. It has five year EPS and revenue growth rates north of 10%, and it is actually navigating very well through challenging times.

Coach: A cheaper way to growth markets
Both Kors and Coach are wise to be investing heavily in emerging markets. Last year the Chinese luxury apparel market grew 10%, as China became the largest luxury consumer in the world. Considering that China still has a long way to go before it is "fully developed," and the sheer mass of its population, this market has a lot of room for both Coach and Kors to run.

The difference, between Coach and Kors, is that Kors is newer to the public markets, and it's smashing analyst expectations. Why should that change the way we view Coach?

Analysts belabor the point that U.S. comps dropped 2% for Coach in its most recent quarter but, as Fool Charly Travers recently noted, declines in Coach's North American business are being offset by rapid growth elsewhere. So while you'll often hear pundits slam Coach for modest market share declines in hand bags, those same pundits don't line up to applaud Coach for growing its meanswear business by 50% in 2013.

Coach's management team has decided to penetrate non hand-bag markets, particularly meanswear, and emerging markets. It's simply impossible to invest in new markets without ceding some market share others. Many companies, such as Apple, have ceded market share in old markets in exchange for rapid growth in new ones.

We should know that expanding out of handbags and accessories has risks. So here's the only question that matters: is Coach making the right decision by expanding beyond handbags and accessories?

Final thought: Stick with Coach
It's fair to question if Coach should be expanding in the way that it has, but would we be questioning it less if it didn't? In its most recent quarter, sales were still up 6% due solely to rapid growth in new markets. While the handbag segment is challenging, I feel Coach would be seeing increased competition in this segment regardless. Just look, again, at Vera Bradley, a business that is much more focused on handbags and accessories, which recently saw a 3.7% same-store decline.

In other words, perhaps we should be applauding Coach's management for having the foresight to diversify outside of handbags.

I believe that investing heavily in emerging markets and meanswear will diversify Coach's business measurably, and I feel that today's prices are a bargain for this wonderful luxury brand.

Coach ranks wonderfully with Greenblatt's formula, and it's moving rapidly into high-growth markets. I'm sticking with Coach.

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Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends Coach. The Motley Fool owns shares of Coach. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published