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MagicDiligence (< 20)

Three Points of Investment

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September 22, 2009 – Comments (0)

Joel Greenblatt's Magic Formula Investing (MFI) strategy is a very simple but very effective design. The two screen components are earnings yield (basically the inverse of P/E, using operating earnings) and return on capital. Stocks with a high earnings yield indicate that they may be under-priced based on past levels of profitability. Stocks with high returns on capital indicate good businesses - ones that possess some kind of competitive advantage, be it structural or managerial, that allows them to earn outstanding returns on shareholders' capital. Combine the two and you get "good companies at cheap prices" - a winning investment recipe, proven through numerous back-tested studies to outperform the market at large.

However, any experienced investor can spot obvious frauds just by perusing the top 50 stocks on the official MFI screen for any given day. Simply because of the way the MFI screen components are calculated, imposters can find their way into the list. Some examples of these imposters are: heavily cyclical commodity stocks after a boom period; fad stocks with no second act that have outlived their year or 2 in the sun; declining businesses in run-off mode with little hope of future growth; and firms that grow exclusively through expensive and risky acquisitions that are hidden by the MFI tactic of removing goodwill assets from return on capital calculations.

MagicDiligence feels there are very few outright terrible choices on the MFI screen - usually a cheap stock price alone gives the investor some reasonable expectation of a profitable investment. And there are numerous "lottery tickets" in MFI - small pharmaceutical companies betting the bank on one or two developmental drugs are just one example of a pick that could earn 500% or more, or go bust. However, the best long term MFI performance is going to come from choosing the truly great businesses that get cheap enough to make enticing investments. So, when analyzing MFI stocks, these three factors are the main things MagicDiligence looks for. They are not the only considerations, but a stock meeting all 3 of them is in most cases an interesting choice for a one year MFI position:

1) Growth Potential

Stocks with low growth potential get tagged with a low P/E ratio (or high earnings yield) - simple as that. This makes sense, of course. Without revenue growth, there is only so much management can do to increase profit margins, the only way to grow earnings. Eventually, profits will follow revenues on the downslide, making what once looked like a bargain price turn into a premium.

However, companies that have good growth prospects and still carry a low valuation make enticing investments. The potential exists not just for an increase in valuation, but also one in actual intrinsic business value with growing earnings. So ask yourself: does this company have good growth potential, especially over the next year and a half or so? Are there plenty of new markets that can be easily exploited with current products or services? Have recent revenue growth rates been respectable? Is this an expanding business instead of a stagnant or contracting one?

2) Financial Health

Another common reason for a low valuation is shaky financial health. MagicDiligence recently posted an in-depth analysis of financial health, and companies that would be (or already are in) risky territory if sales took a dive clearly deserve lower valuations. There are several examples of near-bankruptcy and de-listing in MFI stocks - in 2008 alone both Idearc and Westwood One were removed from the exchanges.

For this one ask yourself: Is this company's debt burden too high for reasonable levels of profits and cash flows? Is there enough cash on the balance sheet to take advantage of the growth opportunities that exist, or fend off irrational tactics by competitors? Is the company especially cyclical and at risk if sales fall off of a cliff, even for a short period of time?

3) Competitive Position

Long-term, a strong competitive position consists of some advantage that competitors cannot match. Some examples of these are a strong brand that allows higher product prices, regulatory barriers to entry, unique assets, or dominating economies of scale. For stocks you plan to hold 5 years or more, a long-term competitive advantage is critical to success, otherwise competitors will whittle away at profit margins and sales growth, and return on capital will return to average levels.

The Magic Formula is a one-year holding period, so these requirements can be relaxed a little, although an MFI stock with long-term competitive advantages always makes for an intriguing investment. Some additional advantages over the short term are: strong business momentum (higher growth rates or margins than competitors in the last 12 months), excellent and proven leadership, or weakness of primary competitors. An MFI stock with some or all of these competitive advantages should be able to maintain good business results over the short-term.

Conclusion

Over an investing career, Magic Formula investors will experience the most success picking MFI stocks that are truly great investments, and three characteristics to look for are good growth prospects, solid financial health, and a strong competitive position. Finding these is the mission of the MagicDiligence Top Buys portfolio.

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