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3 Investment Sectors That Look Oversold

Over many years of following Joel Greenblatt's Magic Formula Investing (MFI) strategy, several patterns have emerged. One pattern I want to illustrate today is how MFI is not only useful for identifying oversold stocks, but also oversold industries.

It is not at all uncommon to see 5 or more direct competitors all show up in MFI at once. There are several potential catalysts for this. Perceived industry-wide risk is a common one. Poor performance by a sector leader can often drag the stock prices of competitors down, sometimes unfairly. Highly cyclical industries often show up in MFI shortly after a boom period, where profitability was high but is not expected to remain so.

There are 3 sectors that are currently heavily represented in MFI by 6 or more stocks (using the 50 over 50 million, 50 over 1 billion, and 30 over 3 billion screens). Let's take a look at each, rank the players in Magic Formula fashion, and then discuss the reasons why the industry is cheap and what the best plays may be.

For Profit Education

Here are the 6 for-profit education firms currently in the screens, ranked from "best" to "worst", according to the strategy's axioms:

TickerCompanyPriceQuarterEYMFI-ROICCRRank
ESIITT Educational Services Inc.$70.732011-03-3127.7%226.9%1.031
CPLACapella Education Company$47.982011-03-3115.7%219.4%5.142
APOLApollo Group, Inc.$42.192011-02-2825.3%151.7%1.443
STRAStrayer Education, Inc.$121.872011-03-3113.4%166.2%1.524
CECOCareer Education Corporation$22.872011-03-3121.8%80.6%1.465
DVDeVry Inc.$53.992011-03-3113.8%102.6%1.486

The catalyst for the low valuations on these stocks is quite easy to identify - government regulation. For the past year, the Department of Education has pushed through new rules on recruitment and disclosure, and the big elephant in the room are the proposed gainful employment rules. Additionally, some of these firms are teetering very close to Title IV limits on cohort default rates and the "90/10" rule, which stipulates that at least 10% of revenue must come from outside of government loans.

In my Strayer (STRA) review, I noted that this industry breaks down into two categories. One is the generally accepted high quality institutions with low risk on Title IV limits but less cheap stock prices (Strayer and DeVry fit here). The other are the institutions that are focused on 2-year vocational programs, service lower income demographics, and have higher cohort default and 90/10 concerns (ITT and CECO fit, and APOL to some extent).

Given the power of the government to affect the business models of this sector, it is probably best to focus on the higher quality plays here. Both Strayer and DeVry look significantly undervalued at present, and are not facing the dramatic enrollment declines that Apollo is suffering.

Chip Equipment Makers

TickerCompanyPriceQuarterEYMFI-ROICCRRank
KLICKulicke and Soffa Industries, Inc.$11.662011-03-3125.6%105.2%3.831
LRCXLam Research Corporation$46.392011-03-3118.9%85.3%3.562
MKSIMKS Instruments, Inc.$25.442011-03-3124.5%65.5%7.483
NVMINova Measuring Instruments Ltd.$10.242011-03-3113.1%228.7%4.014
KLACKLA-Tencor Corporation$41.362011-03-3116.3%73.4%4.005
TERTeradyne Inc.$15.522011-03-3115.0%75.9%3.756
AMATApplied Materials, Inc.$13.082011-01-3113.8%51.3%2.457
NVLSNovellus Systems, Inc.$36.032011-03-3112.9%45.7%4.518

The screen is littered with semiconductor production equipment makers. A push-back of demand during the 2008-09 recession, combined with the explosion of smart-phones and other portable devices led to a boom in demand for chip equipment in 2010. However, this is a notoriously cyclical industry, and many investors feel that demand is starting to wane as capacity catches up. Therefore, those recent profits are not being valued very highly.

There is certainly a wide variety to choose from, from gigantic, entrenched firms like Applied Materials to smaller players like Nova. Both KLA-Tencor and Lam Research have extremely strong competitive positions in larger niches of the industry (KLA in PDC and Lam in Etch), along with sufficiently cheap stock prices and strong balance sheets. They are my two favorite picks here.

Defense Contractors

TickerCompanyPriceQuarterEYMFI-ROICCRRank
OSKOshkosh Corporation$27.022011-03-3127.4%107.1%1.441
CMTLComtech Telecommunications Corp.$27.372011-01-3125.1%106.1%7.932
SAISAIC, Inc.$17.272011-01-3114.1%78.4%2.203
CUBCubic Corporation$49.822011-03-3110.8%123.3%1.884
GDGeneral Dynamics Corporation$71.802011-03-3114.3%72.0%1.315
NOCNorthrop Grumman Corporation$63.752011-03-3115.6%59.9%1.476
RTNRaytheon Company$49.262011-03-3112.0%42.7%1.487
LMTLockheed Martin$75.762011-03-3112.7%30.3%1.198

Defense contractors are cheap for obvious reasons - the U.S. has already pulled out of Iraq, and expectations are that Afghanistan may not be far behind. Defense is also not immune to budget cuts given the absurd deficit and debt load being accumulated by the federal government.

That said, this is a historically stable industry with recession-proof revenues and a history of solid cash flows, good dividends, and predictable growth. In this group, one concern is the diversification of revenues - we don't want to rely on just 1 or 2 programs that may be cut or end at any time (ask Oshkosh or Comtech). Dividend yield is another important concern that is not modeled above. While Lockheed has the highest dividend at 3.9%, I'm a bit concerned about the continuing troubles surrounding the F-35 program. Raytheon sports a solid 3.4% yield and has a highly diversified business, limiting the risks of any individual program. That makes it my favorite pick in this group at present.

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Disclosure: Steve owns CUB

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