4 Magic Formula Stocks Flying under the Radar

By Soroush Pour - June 6, 2012 | Tickers: CVG, GME, HFC, PSX | 0 Comments

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There are hundreds, if not thousands of investing strategies being used in the markets today.  From Benjamin Graham’s intrinsic value methodology to the contrarianism implemented by George Soros, individual investors have a variety of role models to follow. 

One of the most successful tactics put to use over the past couple decades has been Joel Greenblatt’s Magic Formula approach.  With this strategy, Greenblatt focuses on choosing stocks with the unique combination of a high return on invested capital and a high EBIT to enterprise value ratio.  He’s done quite well for himself, as his New York-based Gotham Asset Management fund has achieved an average annual return north of 25 percent since the time of grunge rock and Baywatch.

While these two terms may sound like financial gobbledygook, they are actually quite simple.  The former, or ROIC for short, is a measure of the return that a company attains from investing in its own business.  For example, a company that earns $50,000 from the construction of a new factory worth $150,000 (ROIC of 33.33%) would be preferable over a company that earns $100,000 from the construction of a new factory worth $1 million (ROIC of 10%).  Greenblatt believes that companies with high ROICs usually have a leg up on their competition, whether in the form of a unique product, brand loyalty, or governmental support. 

Moreover, a high EBIT/enterprise value ratio is a similarly desirable indicator of financial success because it measures the earnings potential of a particular stock.  EBIT is earnings before interest and taxes, while enterprise value is a measure of true economic value.

Below are four stocks that are currently in the top 30 of each category.  Each stock has a market capitalization of at least $1.5 billion and is traded on an American exchange.

Convergys Corp (NYSE: CVG)

An information management software company formed in the late '90s, CVG quadrupled in value before the dot-com bubble burst, though it has failed to reach those highs since.  The stock has given investors over 10 percent in the past year, compared to a negative 7.2 percent return for the software industry as a whole.  Currently, Convergys has a stratospheric EBIT/enterprise value of 35.57 and a ROIC of 39.8 percent, placing it in the top one percentile of all publicly traded companies in the U.S.  Moreover, its Price-to-Earnings (5.2X), Price-to-Book (1.1X), and Price-to-Cash Flow (9.6X) ratios are all below industry averages.  Adding the cherry to this proverbial sundae, the company recently announced its first dividend in history, giving shareholders a 1.5 percent yield.

Phillips 66 (NYSE: PSX)

A recent spin-off of ConocoPhillips, this $21 billion downstream oil and gas giant has an EBIT/enterprise value of 30.1, and a ROIC of 38.0 percent.  PSX has lost almost 6 percent in the last month, though it's not uncommon for spin-offs to be undervalued right out of the gate.  For more on how to invest profitably in spin-off plays, see this article.  Back to the point, Phillips 66 has diversified its operations more so than competitors like Valero Energy and Sunoco, holding chemical and midstream assets in addition to its refinery business.  In the intermediate term, the company faces declining gasoline demand in the U.S. and Europe, though corporate execs have stated plans to double exports by 2015.  In the long run though, oil is bullish, and PSX’s $0.80 dividend should see growth based on its payout ratio, which is only 15 percent of expected earnings.

HollyFrontier Corp (NYSE: HFC)

Another oil refining company, HollyFrontier has operations in the western half of the U.S., which gives it a unique competitive advantage.  Compared to its peers that operate in the Gulf Coast region, HFC is much closer to recently tapped shale reserves in North Dakota, Colorado, and California, so the company faces lower feedstock – aka transportation – costs.  This partially explains HFC’s high ROIC (32.6%) and EBIT/enterprise (27.1) values, both of which are exceptional.  Shares of HFC are up almost 23 percent since the start of 2012, and the company recently blew away Q1 earnings estimates, reporting an EPS of $1.16 compared to $0.79 one year earlier.

GameStop Corp (NYSE: GME)

As the go-to spot for cash-strapped gamers everywhere, GameStop currently holds 80 percent of the used video game market.  Driven by its ubiquitous trade-in system, GME has seen strong revenue (34.6%) and earnings (33.3%) growth since the recession, despite a floundering videogame industry, which is discussed here.  Interestingly, shares of GME have been cut in half over this same time, which may be the result of these same economic headwinds.  Currently, the company has an EBIT/enterprise value of 22.9 and an ROIC of 33.8 percent, so now may be a good time to buy.

Keep in mind that the implementation of Joel Greenblatt’s Magic Formula requires patience, as the creator himself notes that five out of every 12 months, and one out of every four years yield negative results.  In the long run, however, there may not be a strategy that is as simple and effective at generating double-digit returns.

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