Examples Of Poor "Magic Formula" Stocks

Joel Greenblatt's The Little Book That Beats The Market was a landmark book in value investing. In a little over 150 pages, he concisely explained how two simple factors - Earnings Yield (EY) and Return on Tangible Capital (ROTC) - could be used to find attractive stocks to outperform the market. And outperform it did! Over the 17 years of back testing from 1988 to 2004, the Magic Formula produced annual investment returns of 30.8% versus the S&P 500's return of 12.8%.

However, a look at some of the stocks that appear on the Magic Formula Investing (MFI) screen reveals that some are rather obviously poor investments. The screen will uncover companies with fad products, where success is unlikely to be repeated. Some companies have such a low valuation due to financial or management problems. Still others are hanging on in a dying industry. Companies in cyclical, commodity-based industries will often be screened at the top of the price cycle and discarded at the bottom. This, of course, is the opposite of how to invest in cyclical stocks.

There are 4 primary criteria an investor can use to find the best Magic Formula opportunities. Stocks that fail one or more can be discarded. By doing this, an investor following the MFI strategy can put him or herself in the best position for potential success. This article will list each criteria, and provide an example of a current Magic Formula stock that can be discarded based on it.

1) Financially healthy with strong, reliable cash flows, reasonable debt, and durable competitive advantages.

An example of a stock not meeting this criteria is Idearc (IAR). This company was recently spun off from Verizon, and they publish the yellow pages books in areas where Verizon is the local carrier. They also run yellowpages.com. The problem with IAR is that Verizon saddled the company with a large debt load. Debt interest eats up 50% of operating earnings, leaving the company with a paltry 2.0 coverage ratio. This leaves very little wiggle room if something goes wrong in the business. What's more, advertising dollars are trending online, phone directories are more easily searched online, and cell phones are increasingly more capable of accessing online directories. This is a bad combination for Idearc's future prospects.

2) Are not the beneficiary of a one-time "fad" product.

Heely's (HLYS) is a classic fad product company. The company had a huge breakthrough last fall with their sneaker/rollerskate combination shoes. But the demographic - pre-teens - is a notoriously fickle group where fads go to rise and fall, often within the span of a year or two. Heely's has given no indication they can follow up with another great product to maintain earnings. The ROTC is based on last year's fad, and the EY is based on the bleak outlook going forward. It is unlikely the company will ever regain their prior success.

3) Have experienced and trustworthy management, by all available indications.

This one is more subjective, and probably accounts for the fewest discards. One example is King Pharmaceuticals (KG). The company has constantly had to take one time charges and restate earnings due to accounting issues. The question here is, can we trust the financial results on which the Magic Formula statistics are based? Until proven otherwise, play it safe and look elsewhere to invest.

This rule is particularly important for small cap stocks. Small companies are more dependent on good management to grow and survive. It's important to look for large insider ownership and good results for years before even considering a micro or small cap company.

4) Are not operating in a declining industry with poor future prospects.

Can you believe there are companies that still make pagers, over 10 years after cell phones became mainstream? There are, and one of them is a perennial top 25 Magic Formula stock - USA Mobility (USMO). Pagers still exist, but are quickly losing their price advantages and will soon go the way of the telegram, telegraph, and carrier pigeon. USMO is facing quickly declining revenues and without sales growth, no company can grow earnings for very long. USMO is an easy discard.

By using the above criteria and a little investigative work, a moderately experienced investor can greatly reduce his potential risk in following the Magic Formula stock strategy.

Steven Alexander is the founder and voice behind MagicDiligence ( http://www.magicdiligence.com ), a website dedicated to researching stocks appearing in Joel Greenblatt's Magic Formula Investing screen.

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