Magic Formula With A Dash Of Quadrix
In the bestseller The Little Book that Beats the Market, author Joel Greenblatt describes a “magic formula” that delivers strong results investing in the type of stocks we tend to favor — high-quality value plays. We put Greenblatt’s approach to work and added a Quadrix® screen to uncover 16 attractive picks.
While Quadrix evaluates more than 100 variables, Greenblatt’s formula considers just two:
Return on capital. Quality companies typically earn a high return on capital, allowing them to reinvest profits at higher rates of return, which should in turn drive strong profit growth. Return on capital equals earnings before interest and taxes (EBIT) divided by the sum of net working capital and net fixed assets. Net working capital equals current assets minus current liabilities, while net fixed assets equals property, plant, and equipment minus accumulated depreciation.
Earnings yield. Companies are generally more desirable when they earn high profits relative to their market value. A measure of valuation, earnings yield equals EBIT divided by the sum of long-term debt and market capitalization (stock price times shares outstanding). Traditional earnings-yield calculations use operating profits rather than EBIT, but Greenblatt’s version accounts for debt levels and tax rates.
Investors seeking to apply the “magic formula” face a large hurdle — it can be difficult to emulate. Greenblatt’s approach requires reams of financial data not available in bulk to most investors. In addition, the metrics can present problems for certain types of stocks, so Greenblatt suggests not using the magic formula on utilities, financials, and international companies.
Fortunately, we’ve done the work for you. The table below lists 19 recommended stocks that earn high scores for return on capital and earnings yield. In fact, all 19 score among the top 25% of S&P 1500 Index stocks based on the combined rank for return on capital and earnings yield. As an extra screen, all 19 earn Quadrix Overall scores above 80, meaning they rank among the top 20% of U.S. stocks. Four favorites are reviewed below.
High return on capital and earnings yield secure GameStop’s ($26; GME) place in the top 2% of S&P 1500 stocks for combined rank. In the October quarter, per-share profits dipped 6% to $0.32 excluding one-time costs, topping the consensus by $0.02. GameStop’s revenue advanced 8%, well above the 2% consensus, on strong growth in used products and new software. A decline in hardware sales contributed to 7.8% lower same-store sales.
The stock’s disappointing performance — down 15% since April — in part reflects weakness in the videogame industry. Although robust early in the recession, videogame sales have eroded 13% industrywide so far this year. The new Call of Duty: Modern Warfare 2 videogame sold a record 4.7 million copies for $310 million on Nov. 10, the day of its launch. As many as 13 million copies of the game are expected to sell by the end of the year. Few other high-profile games are expected to launch before next year, but early spending trends suggest videogames will be one of stronger retail niches this holiday season.
Industry weakness notwithstanding, GameStop looks unduly cheap for a company expected to grow per-share earnings at an annualized rate of 15% over the next five years. The stock trades at less than 10 times the most conservative estimate for fiscal 2011 ending January. GameStop is a Buy.
IBM ($128; IBM) regards business-analytics software — programs that help analyze data across industries — as a key growth opportunity. Applications range from finding cross-selling opportunities in retail to compiling health-care information to analyzing risk in financial settings. IBM has spent $6.2 billion on two major analytics acquisitions in the past three years and plans to funnel more money into the niche market, which IBM says is worth an estimated $105 billion and growing at an annual rate of at least 7%.
In November, IBM signed a deal to provide analytics software for Jackson Hewitt Tax Service ($4; JTX) locations nationwide. Also in November, IBM raised its visibility in the analytics space by opening its sixth analytics solution center, this one in Washington, D.C. The company plans to continue expanding this business worldwide, with London the next target.
Ranked in the top 6% of stocks in the S&P 1500 for return on capital, IBM has squeezed higher profits from shrinking sales over the past year. Strong operating performance has IBM on track to reach its target of at least $10 per share in profits next year. IBM has also generated higher free cash flow in each of the last four quarters and holds $11.51 billion, or $8.60 per share, in cash. IBM is a Focus List Buy and a Long-Term Buy.
National Oilwell Varco ($44; NOV) is gushing with liquidity. In the past year, the rig builder and outfitter has fortified its balance sheet by increasing cash assets 81% to $3.19 billion, or $7.63 per share, and reducing long-term debt 41% to $875 million. In November, National Oilwell initiated a quarterly dividend of $0.10 per share and announced a one-time special dividend of $1.00 per share, both payable Dec. 16, for a total of $460 million in distributions.
While deepwater drilling has propped up the energy industry, onshore drilling is another story. Demand for land rigs plunged 51% this year, and new rigs continue to flood the market. U.S. utilization fell to 39% in November, the lowest level since 1986. National Oilwell controls an estimated 25% of the market for new orders of land rigs, which seems likely to remain under pressure. National Oilwell also appears poised to grab a bigger slice of the market for offshore floaters next year.
Wall Street forecasts lower per-share earnings in 2009 and 2010, but estimates are rising. National Oilwell has exceeded consensus profit estimates in each of the past four quarters, but order rates for the September quarter were disappointing. At 10 times trailing earnings, the stock trades 53% below the five-year average. Earning a combined rank of 94, National Oilwell Varco is a Buy and a Long-Term Buy.