Here’s Another Magic Formula Stock for Your Portfolio
Soroush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Back in June, we shared hedge fund manager Joel Greenblatt’s investment strategy with you, aptly known as the Magic Formula approach. In this article, we explained that Convergys, Phillips 66, HollyFrontier, and GameStop exhibited the unique combination of: (1) a high return on invested capital, or ROIC, and (2) a high EBIT to enterprise value ratio. While there are many different indicators used for investment evaluation, Greenblatt believes these two are the top dogs in the financial world, and his illustrious career has proved just that. Aside from writing “You Can Be a Stock Market Genius,” Greenblatt also manages the $1.2 billion Gotham Asset Management, which has averaged an annualized return of more than 25% since its inception in 1985.
Now, to check up on our last four recommendations, we can see that PSX (28.0%) and HFC (24.9%) have outperformed the S&P 500 (8.8%) quite handily over the past two months, though CVG (7.7%) and GME (-17.8%) have underperformed. Still, a hypothetical portfolio made up of each stock at an equal weight would have generated an alpha of 1.9 in a little over two months; not too shabby at all. Due to popular demand, we’ve decided to share one more stock that has that “magic” spark. Enjoy.
CF Industries Holdings (NYSE: CF)
As discussed here, record grain prices are expected to dent the wallet of the American consumer, but it should provide a boost to fertilizer companies like CF Industries. One of the largest producers of nitrogen and phosphate fertilizer in the Western Hemisphere, CF is in an enviable position indeed. In 2012, the stock has jumped nearly 40%, and a host of valuation indicators show that more appreciation may be on the horizon. With an ROIC north of 60%, and an EBIT/enterprise value of 31.7, the company has generated superior returns from investing in its own business and still has room to grow.
Moreover, shares of CF are currently trading at a price-to-earnings ratio (8.5X) below the agricultural inputs industry average (13.7X) and peers like Agrium (NYSE: AGU) at 10.0X, Potash Corporation of Saskatchewan (NYSE: POT) at 14.9X, Intrepid Potash (NYSE: IPI) at 18.3X, and Monsanto (NYSE: MON) at 21.8X. This undervaluation is not warranted, as CF sports a 3-year average annual EPS growth (21.9%) higher than industry norms (7.7%) and the likes of AGU (4.5%), POT (-1.5%), IPI (3.4%), and MON (-6.2%).
Furthering this argument, we can see that CF sports a paltry PEG ratio of 0.3; typically any figure below 1.0 signals that investors have yet to fully appreciate a stock’s earnings growth. Historically speaking, CF Industries’ earnings have traded at a 9% discount to those of the S&P 500 since its IPO in 2005. This year, they trade at a much cheaper discount of 42%. From a cash standpoint, CF is trading at a price-to-cash flow ratio (6.9X) below the industry average (11.4X), AGU (8.3X), POT (11.3X), IPI (8.5X), and MON (17.3X), despite the fact that it has grown its operating (194.8%) and free (293.3%) cash flows at impressive rates over the past three years.
On August 6th, the company reported second quarter earnings of $8.71 a share, slightly above the average analyst estimate ($8.66), and a 29% gain from Q2 of 2011. By year’s end, analysts are forecasting CF to reach earnings of $26.46 a share, up 15.5% from the $22.90 it reported in 2011. If CF is able to hit these targets, fairly valued shares could eclipse $240; they currently trade in the $200 range. WealthLift’s Sentiment Index rates CF as a strong buy, with nearly all of the community’s users placing an “overperform” rating on the stock.
WealthLift has no positions in the stocks mentioned above. The Motley Fool owns shares of CF Industries Holdings. Motley Fool newsletter services recommend PotashCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.