Two Magic Formula Stocks for Week of January 9, 2012
Tom is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is no investing technique that works successfully, with known certainty, in every situation. There are, however, certain ways to think about allocating investment dollars that have led to higher than average investment returns over the long run. Joel Greenblatt’s Magic Formula Investing strategy, despite its cheesy name (it is no get-rich-quick gimmick, as if one existed), is one of these techniques that has done an excellent job beating the masses over the past several decades.
There is obviously nothing inherently magical about Greenblatt’s published ideas – the masses of investors who would eventually discover and use the formula’s teachings would further improve the efficiency of the market’s prices and reduce the ability for the formula to generate excess gains over time. Instead, the so-called formula is simply a smart, value-focused way of thinking about asset allocation. Investors should actively seek out efficient assets – those that generate higher than average returns – and seek to purchase those assets inexpensively.
Specifically, by examining the return on invested capital (basically working capital plus net fixed assets employed) and the firm’s EBIT multiple (defined by earnings before interest and taxes divided by enterprise value), Greenblatt has reported an annual 30+% return using the Magic Formula Investing strategy. These results are enviable enough to take a closer look at this investment technique.
Good, But Not Perfect
Because the technique is not subjective – it is a simple ranking strategy using the two metrics listed above – there are obviously going to be some stocks that will make the selective list that are not necessarily worthy of one’s investment dollars.
At recent market prices for AMAT and KLAC of $11.01 and $47.73, respectively, both stocks appear to be quite inexpensive on the surface. The first two metrics are Magic Formula-specific:
RNOA defined as post-tax operating income divided by the average net operating assets (NOA) employed throughout the year. NOA = (Operating Assets – Financial Assets) – (Operating Liabilities – Financing Liabilities). Examples of each category: operating Assets (accounts receivable, PPE, etc.), financial assets (excess cash and marketable securities), operating liabilities (accounts payable, accrued liabilities, etc.), financial liabilities (long term debt, interest-bearing notes payable, etc.).
AMAT and KLAC both appear to offer an investor access to a collection of efficient assets, all trading at relatively attractive prices. However, does either of these stocks offer a suitable margin of safety in their current market prices? Delving deeper into the past performance of both corporations seems to show that they in fact do not.
The following two charts show the post-tax return on net operating assets and the subsequent residual operating incomes generated by each corporation over the past ten years. Residual operating incomes are calculated using cost of capital requirements of 14.5%. Both firms’ return on net operating asset levels for the most recent twelve month period are significantly higher than their ten year averages (AMAT 112% higher, KLAC 127% higher). Prospective and current investors in both of these corporations alike should ask themselves whether or not they believe these higher performance results are sustainable, because the market is more than pricing the recent good news into each stock’s per share price.
ReOI = Residual Operating Income calculated with 14.5% charge to RNOA to account for cost of capital.
Anchoring on each firm’s book value per share and utilizing short-term accounting to factor in the additional value created by their per share residual earnings generation over the past twelve month period, a rough estimation of the per share prices is as follows:
Per share equity price = Book value per share + [(Residual earnings per share) / (1.145 * (.145 – g))]
AMAT price per share estimation = $6.74 + [($1.08) / (1.145 * (.145 – 0))]
Estimated price per AMAT share: $13.25
KLAC price per share estimation = $17.61 + [($3.66) / (1.145 * (.145 – 0))]
Estimated price per KLAC share: $39.66
To be conservative, no growth in per share residual operating income was assumed. However, it was assumed that each firm will continue to generate excess returns at this rate indefinitely into the future (basically a perpetuity). This in and of itself might be deemed to be quite non-conservative. After coming off such huge performance improvements in the past twelve month period, is it reasonable to assume that such high growth will continue? Or is this simply a return to “normalcy” after the recent downturn both companies experienced in 2009 and most of 2010? In this valuation, I'm hypothesizing that the truth is closer to the latter.
Although both estimations are rough, they do show that at current market prices of $11.01 and $47.73 for AMAT and KLAC, respectively, the market is assuming that this stronger than average performance will continue well into the future. These assumptions, when looking at the past history of both corporations, hardly factor in any meaningful margin of safety to protect from possible future investment losses (for a risk-averse, value-focused investor anyways).
It is impossible to speak for every investor when discussing a subjective topic like margins of safety – every investor has different risk profiles and some are obviously more willing to take on higher levels of risk than others. Prospective and current investors in both of these corporations should, however, not forget to ask themselves these two questions before looking any further into AMAT and KLAC:
- How will each corporation manage to maintain a long-term competitive advantage to continue to protect their last twelve month returns on net operating assets of 50+%? Especially in a competition-laden manufacturing sector, existing competition and new entrants will tend to diminish these very attractive returns over time. Remember that this good performance is priced into each corporation’s stock…if you’re paying for it, you should know with a high degree of certainty that it cannot disappear with significant ease.
- How can you (the investors themselves) maintain a knowledge-based competitive advantage on these two stocks when compared to the average investor? Especially for companies of this size, it becomes increasingly difficult to know more than the average investor, and prices are thus relatively efficient. Will a simple buy and hold (buy and hope?) strategy have a high probability of leading to superior investment returns?
As for me, I’ll pass in this round, but will continue to occasionally utilize the Magic Formula Investing technique to see if more attractive prospects come along.
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