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MagicDiligence (< 20)

Using Magic Formula Investing to Rank Any List of Stocks

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April 26, 2011 – Comments (0) | RELATED TICKERS: DPS , KSS , MSFT

Magic Formula Investing, or MFI, is based on a process, not on hard limits. The process is simply applied on a "basket" of stocks, producing a relative ranking for each stock in that basket based on a composite of earnings yield and adjusted return on capital. The result you get is your basket ranked from 1-N, with lower rankings indicating good companies selling at cheap prices.

The strategy on a whole is usually applied to all U.S.-listed stocks over $50 million market cap, to find the market's most attractive "quality-at-value" opportunities. However, it doesn't have to be used in this manner. It is perfectly viable to apply MFI's tenets to smaller baskets of stocks to compare investment opportunities.

In fact, using MFI buys you a lot of advantages over more traditional price-to-earnings (P/E) and return on equity comparisons:

1) MFI uses enterprise value instead of market capitalization when calculating the earnings yield. This has the effect of penalizing firms with a lot of debt, while at the same time rewarding firms with a lot of cash on the balance sheet.

2) MFI uses operating earnings instead of net earnings when calculating the earnings yield. This eliminates the one-time charges that can distort P/E ratios, and also ignores the effects of unpredictable (and often non-recurring) tax provisions.

3) By using return on *tangible* capital (i.e., subtracting goodwill and intangible assets), and removing excess cash, MFI is comparing most firms on an apples-to-apples basis, instead of relying on some purely accounting assumptions for the value of assets.

With this in mind, let's look at a few examples of using MFI to compare investment opportunities. All of these examples were generated with MagicDiligence's Portfolio Stats Calculator.

Case #1: The "Pepsi Challenge" (PEP vs. KO vs. DPS)

Let's start with a very simple comparison: the three major soda pop makers. Which one of Coke, Pepsi, or Dr. Pepper is the best balance of high returns on capital combined with a low stock price? Taste was not considered:

TickerCompanyPriceQuarterEYMFI-ROICCRRank DPSDr Pepper Snapple Group, Inc.$38.862010-12-318.9%45.3%0.981 PEPPepsiCo Inc.$67.142010-12-316.3%30.8%1.112 KOThe Coca-Cola Company$67.502010-12-314.8%25.0%1.173

Dr. Pepper Snapple Group wins pretty handily, taking both the highest earnings yield and highest returns on capital. PepsiCo slots in second, and Coca-Cola comes in last with both the lowest earnings yield and returns on capital. The "CR" column is current ratio, a measure of financial health. Higher values are better - usually we like to see 1.0 and up.

Case #2: Large Department Store Retailers

Using MFI stats on competitors in a certain industry is useful on a larger scale too. While there are really only 3 major soda makers, there are several large department store retailers. Say you wanted to add some retail to your portfolio, but are unsure of which stock(s) to add? Let's take a look at a bunch of them, ranked in the MFI manner:

TickerCompanyPriceQuarterEYMFI-ROICCRRank KSSKohls Corporation$52.062011-01-3112.2%21.8%2.081 MMacy's Inc.$23.872011-01-3111.9%18.9%1.362 WMTWal-Mart Stores, Inc.$53.292011-01-3110.3%21.7%0.893 TGTTarget Corporation$49.732011-01-3110.4%16.4%1.714 JCPJ.C. Penney Company Inc.$37.332011-01-318.9%10.7%2.415 DDSDillards Inc.$44.952011-01-319.4%10.4%2.056 SKSSaks Incorporated$11.402011-01-314.9%6.5%2.207 SHLDSears Holdings Corporation$82.292011-01-313.8%3.8%1.348

A few things stand out here. One, most of the large retailers look pretty cheap, with earnings yields of 9% or higher (you can compare earnings yield to a bond or CD). Second, this industry is not particularly capital efficient, with returns on tangible capital in the 10-20% range. Most "official" Magic Formula stocks boast 50% or higher.

In this group, Kohl's wins the outright crown, with the cheapest stock price and most efficient operations. The middle is pretty bunched up, and lastly Sachs and especially Sears bringing up the rear. Prospective investors would have to justify Sears' weak profitability and fairly high valuation - is Eddie Lampert's name really worth it?

Case #3: The Dow 30

The method can also be applied to the popular indexes. To keep the example simple, we'll use the smallest of them, the 30 Dow Industrial stocks. Here they are in ranked order:

TickerCompanyPriceQuarterEYMFI-ROICCRRank MSFTMicrosoft Corporation$25.522010-12-3113.7%137.9%2.461 INTCIntel Corporation$21.462010-12-3114.5%47.9%3.392 HPQHewlett Packard Co.$40.922011-01-3112.8%51.3%1.183 CSCOCisco Systems, Inc.$16.952011-01-3111.4%64.7%2.814 MMM3M Company$93.982010-12-318.6%48.4%2.015 PFEPfizer Inc.$19.942010-12-319.7%40.2%2.116 UTXUnited Technologies Corporation$86.822010-12-318.3%47.1%1.337 WMTWal-Mart Stores, Inc.$53.292011-01-3110.3%21.7%0.898 CVXChevron Corporation$106.762010-12-3111.5%17.8%1.689 IBMInternational Business Machines Corporation$168.302010-12-317.5%41.1%1.1910 PGProcter & Gamble Co.$62.982010-12-316.9%44.1%0.8011 MCDMcDonald's Corporation$76.632010-12-317.9%29.2%1.4912 GEGeneral Electric Company$20.102010-12-3113.6%13.3%3.0113 XOMExxon Mobil Corporation$86.002010-12-319.1%16.9%0.9414 DISThe Walt Disney Company$42.212010-12-317.8%23.8%1.1015 JNJJohnson & Johnson$64.172010-12-316.9%37.7%2.0516 HDHome Depot, Inc.$37.372011-01-318.2%19.9%1.3317 BAThe Boeing Company$75.032010-12-317.4%22.3%1.1518 KFTKraft Foods Inc.$33.212010-12-316.7%33.2%1.0419 VZVerizon Communications$36.892010-12-318.8%14.0%0.7320 KOThe Coca-Cola Company$67.502010-12-314.8%25.0%1.1721 TAT&T Inc.$30.602010-12-317.4%15.6%0.5922 DDE. I. du Pont de Nemours and Company (DuPont)$54.932010-12-316.1%17.3%2.0323 CATCaterpillar Inc.$108.112010-12-316.4%14.1%1.4524 AAAlcoa, Inc.$16.722010-12-315.1%4.5%1.3125 MRKMerck & Co Inc.$34.122010-12-313.0%11.8%1.8626

The Dow tech stocks dominate the top of the rankings. These are and have been very profitable firms, and the recent sell-off in tech has made them attractive on a valuation basis. Several of these are screened into the "official" Magic Formula lists at current.

Also, close lookers may have noticed that 4 of the Dow stocks are missing: American Express (AXP), Bank of America (BAC), JP Morgan (JPM), and Travelers (TRV). The method of ranking unfortunately does not work for financial stocks such as banks and insurance companies.

Conclusion

Ranking groups of stocks by the Magic Formula method is an interesting way to filter down to the most attractive opportunities out of a basket of choices. It's not perfect. For one, dividend yield is not considered, and we are comparing statistics against past earnings with little regard for future prospects. But it is a simple, meaningful way to find stocks for further consideration.


Disclosure: Steve owns MSFT

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