A Different Magic Formula

By Will Ashworth | February 23, 2010 AAA

Many serious investors are becoming familiar with Joel Greenblatt's "Magic Formula," where he takes the earnings yield and return on capital for a group of stocks, ranks them from best (ranked #1) to worst and then adds the two numbers together. The lower a company's combined score, the better. When it comes to screening stocks, this kind of exercise is great because it combines more than one attribute, allowing for a little wiggle room.

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For example, just because a stock's price-to-sales ratio is above the industry average, doesn't mean it isn't a good buy. To illustrate this point, here are the largest processed and packaged goods companies analyzed using forward price-to-earnings, price-to-book, price-to-sales and price-to-cash flow as screening criteria. While it isn't perfect, the "Magic Formula" serves a useful purpose.

Top 10 U.S. Processed and Packaged Goods Companies

Combined My Formula Score Magic Formula Score Combined Score
Campbell Soup (NYSE:CPB) 21 2 23
Ralcorp (NYSE:RAH) 11 13 24
Con Agra (NYSE:CAG) 9 16 25
Sara Lee (NYSE:SLE) 13 15 28
McCormick & Company (NYSE:MKC) 24 5 29
Kellogg (NYSE:K) 26 6 32
JM Smucker (NYSE:SJM) 18 15 33
General Mills (NYSE:GIS) 26 9 35
Pepsico (NYSE:PEP) 29 9 38
Green Mountain Coffee Roasters (Nasdaq:GMCR) 38 19 57

We Have A Winner
Campbell Soup came out on top when combining my formula, which tends to favor value-oriented stocks, with Greenblatt's "Magic Formula," which favors those with strong earnings. While one of Greenblatt's two criteria is return on invested capital, I tend to favor the cash return on invested capital (CROIC) instead because it gives a better idea of a company's cash generation from operations. The higher the return the better.

In Campbell Soup's case, it came out on top at 18.5% with Pepsico second at 17.1% and McCormick & Company third at 13%. With CROIC replacing ROIC, Campbell Soup had the lowest Magic Formula ranking followed by McCormick & Company and Kellogg.

Green Mountain Too Hot
Coming in last is Green Mountain Coffee Roasters, the second best stock performer of the past decade. I like the company and its management but its stock is expensive. The winner using my formula is Con Agra, the maker of Orville Redenbacher's, Chef Boyardee and Healthy Choice brands. Morningstar gives it just two stars because of its lack of innovation and I would tend to agree. It's one reason why its stock is cheap - it's hard to get excited about its products. None of them stands out in a crowd. As for Campbell Soup, it finished middle of the pack using my formula, which is just fine.

Making Sense Of It All
Investment analysis is a lot like analyzing baseball statistics in that you can take all sorts of numbers and contort them into seemingly meaningless variables all in hopes of better understanding the company or player you're interested in.

You likely wouldn't compare the home run production of designated hitters with those of second basemen, but you would compare the home run stats of all 30 second basemen in Major League Baseball looking for that special combination of power, speed and fielding. Investing is no different. Using formulas like Greenblatt's, you see businesses from different sides, making it easier to spot the winners.

The Bottom Line
Campbell Soup cut its 2010 sales guidance February 17 as it continues to struggle with its soup business. It's not a huge concern as profitability won't change much, but management continues to look for ways to grow its legacy brand beyond current levels. As long as earnings remain strong, this tinkering is a sign they're not being complacent.

Have you ever wondered why its return on equity is 71.6%? The company repurchases its shares in huge quantities, reducing overall shareholder equity. In the past three years, Campbell has bought back $2.57 billion of its stock at an average price of $35.21 a share. While it has paid more for the shares than the equivalent amount it is worth today, that likely won't be the case for much longer. (Make an informed decision about your investments with these easy equations. For more information, see Analyze Investments Quickly With Ratios.)

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