No, this is not some article about businesses with mystical products or some fantastic secret formula. The only magical thing about these stocks is that they come from a pre-screened list humbly known as the Magic Formula.
A Successful Recipe
The Magic Formula is a stock screen created by investor Joel Greenblatt based after his bestselling book, "The Little Book That Beats the Market". Greenblatt's criteria is painfully simple. He screens for stocks that meet two criteria: a high return on invested capital (ROIC) along with an attractive earnings yield. The earnings yield is the reverse of the P/E ratio. So in essence, the lower the P/E, the higher the earnings yield. Clearly, with all else equal, investors should prefer to invest in lower P/E or higher earnings-yield stocks. A strong ROIC simply means that a company is creating value for investors by earning above its cost of capital. In simplistic terms, a business that borrows $1 at 8% interest and can generate above 8% on that dollar is creating value.
According to Greenblatt, active use of the Magic Formula stock screener works incredibly well. Back testing done by Greenblatt indicates that following the Magic Formula approach beginning in 1999 would have led to a near 300% return 10 years later. Greenblatt is the first to admit that these are back-tested results, but you get the idea. Because the screener is dynamic, Greenblatt has a simple three-step process for getting the most out of the Magic Formula.
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First, screen for top-ranked stocks at www.magicformulainvesting.com. Second, buy those top-ranked stocks. Third, hold them for one year and sell. Then repeat steps 1-3. While I personally will always demand rigorous analysis of my holdings, I can think of a lot worse things that investors do when picking stocks. I use Greenblatt's screen often for a source of ideas for my professional funds, so it would be a very sound idea for individual investors. (For related reading, check out What Are A Stock's 'Fundamentals'?)
Stocks For Thought
A quick run through a Magic Formula screen yields names like Oncothyreon (Nasdaq: ONTY), a clinical stage biopharmaceutical company developing therapies to fight cancer. The company has one lead product in Phase III development and a pipeline of other products in early stages. Shares trade for $5, and the company has over $1.25 in net cash per share and trades at book value. It merits a closer look. (For more, check out Value By The Book.)
A couple of Chinese stocks also show up on the list. China Education Alliance (NYSE: CEU) is a leading provider of online tutoring and educational services in China. CEU is a small but rapidly growing player in the online Chinese education market. While it flies under the radar screen to larger and more publicly known names like New Oriental Education (NYSE: EDU), CEU trades for under 10 times forward earnings against a multiple of 25 for New Oriental. And CEU's profit margins of nearly 40% are nearly double New Oriental's margins.
In addition to smaller caps, some larger quality names also show up on the Magic Formula screen. Names like giant aerospace company Raytheon (NYSE: RTN) show up on the radar and for good reason. The company trades at a 10 earnings multiple, has no net debt, and return on equity is above 20 percent.
The Key Is 'Cheap'
Whether large cap or small cap, what matters most is paying the most attractive price for a company creating the most value. This stock screen focuses on those two metrics and should serve as an indispensable investment aid. (For more, check out The Value Investor's Handbook.)
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