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MagicDiligence (< 20)

Three Red Flags to Look for in Magic Formula Stocks



February 23, 2010 – Comments (0) | RELATED TICKERS: JHTXQ.DL , SPOK , SNTA.DL

Over the course of the past 2 years following and reviewing stocks in Joel Greenblatt's Magic Formula Investing (MFI) strategy (official screen), there have been a number of recurring themes that have occurred in the population of stocks screened in. These themes range across a number of characteristics: industry, product, business model characteristics, capital structure, and so forth. Today, I want to talk about possibly the most important one: common traits that cause what I call "Magic Formula mirages".

As many readers know, Greenblatt laid out the MFI strategy in his book The Little Book that Beats the Market. Stocks are ranked by just two metrics: earnings yield and return on capital, both altered from the traditional calculation to improve the ability to compare differing accounting and financial characteristics. The highest composite ranked stocks with these two metrics are presented as recommended stocks to purchase. The idea is that combining high earnings yield as a sign of a cheap stock price, with high return on capital as the mark of a good business, MFI investors purchase only good businesses trading at cheap prices.

A "Magic Formula mirage" is a screened stock that, after some due diligence, clearly does not meet the goal of "good business at a cheap price". MagicDiligence has dug up several of these in the past, and almost always the reason why boils down to one of 3 red flags. In order of importance, they are:

1) Non-Recurring Revenue Windfall

Non-recurring or one-time revenue windfalls are perhaps the most common and important red flag from a Magic Formula stock. These one-time gains push operating earnings well north of what they will be in the future when those windfalls disappear. This distorts both earnings yield and return on capital, which both use operating earnings as a variable. Earnings yield is high because the market understands the one-time nature of profit levels, and the stock is priced more towards future expectations. Return on capital is high because the capital base generally produces much smaller profits.

The most common examples of this are development stage drug firms. One current MFI stock matching this description is Synta Pharmaceuticals (SNTA). They received a huge $115 million dollar one-time payment from GlaxoSmithKline (GSK) to terminate a joint venture on Elesclomol, a skin cancer drug, after poor Phase 2 results. To put this in perspective, Synta has never earned a dime off of product sale royalties, and in 2005 and 2006, reported exactly zero revenues!

2) Poor Financial Health

A distant second place, poor financial health is another thing that happens occasionally with MFI stocks. Because MFI uses enterprise value instead of market cap when valuing a stock, debt is penalized mechanically, so this red flag is not as common. It is dangerous, though. A firm with a large debt load, high interest payment obligations, and barely the cash flow to cover them is a bankruptcy candidate, possibly sending your investment to zero. Financial health is an important factor to understand, and I've written in detail about how to analyze it in the past.

There are a few current MFI stocks in financial health danger, perhaps none more so than tax preparer Jackson Hewitt (JTX). After 2 years of misbehaving franchisees, poor franchisee relations, and inept management, Jackson Hewitt has seen operating earnings more than halved. The company's capital structure has nearly nothing in cash but over $300 million in debt. Operating earnings only cover interest payments 3 times over, a very tight ratio.

Dig deeper and the problems are worse. Refund anticipation loans (RALs) are an important part of JTX's business, but they were only able to secure 50% of the funds they needed for 2010. The company is barely exceeding the financial requirements on their credit facility as it is, so the RAL problem is dire. Jackson Hewitt may be able to restructure the facility for the second year in a row, but if they cannot, this is a company in trouble.

3) Declining Businesses

Firms with little chance of profitably reversing a terminally declining revenue base are usually priced to reflect it. This fact gives them a high earnings yield. They may still run a profitable business, but it is unlikely these high returns on capital can be applied to towards new growth investments. While there may be some valuation growth to be had, MagicDiligence likes to see the double play of earnings growth and valuation growth to provide the most "satisfactory" returns!

A classic current MFI example is USA Mobility (USMO). The company's business is electronic pagers, which if you can believe it or not are still commonly used in healthcare, government, and emergency services. Clearly this is a declining business, and USMO's results have spelled this out, with revenue declining at high-teens percentage rates for each of the past 4 years. The market knows it will continue to decline and has tagged USMO with a massively high earnings yield over 35%. Eventually, revenue growth is the flour for making the dough from stock price or dividend appreciation, and USMO does not and likely will not have it.

For more info, check out the free MFI stats calculator, which automatically points out stocks that may fail these red flag tests.

Steve owns no position in any stocks discussed in this article.

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