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3 Replacement Stocks for Magic Formula Investing

MagicDiligence is getting out the chef's hat and apron today and going to work cooking up a new Magic Formula Investing (MFI) dish for investors to taste! Joel Greenblatt, the founder of MFI, explained the strategy in somewhat broad terms in his book The Little Book that Beats the Market, but the exact calculations have always been a bit of a mystery. We know the spirit of the two statistics. Earnings yield is defined as (EBIT / Enterprise value). Return on capital is defined as (EBIT /Tangible invested capital). Many have tried to duplicate it, and MagicDiligence too has tools to calculate MFI statistics for any stock.

Using these tools, I've found what looks like a few discrepancies between my calculations and those on the official site. So, let's break out the ginsu knife and cut out 3 of the "official" stocks that don't make sense, and replace them with some true high rankers that, for unknown reasons, don't screen officially. The screen we're working with here is the top 50 stocks over 50 million market cap.

Cut Off These "Official" Picks

1) H&R Block (HRB). H&R Block is not an expensive stock, but doesn't look either particularly cheap or super-efficient. By my calculations, MFI earnings yield is 8.7% and return on capital is 22%, neither of which should screen the stock into the top 50. I am not exactly sure what Greenblatt is doing with H&R Block's roughly $500 million in mortgage loans held for investment. Since Block includes interest income as part of operating earnings, they should be added to invested capital. Even taking them out does not dramatically improve return on capital. I'm throwing Block out of the screen.

2) China North East Petroleum (NEP). We know from the man himself that Greenblatt has specifically filtered out Chinese reverese take-overs from MFI after they littered the screen in 2009. So why does NEP remain? They have a history of SEC filing delays and a rotating door at CFO, putting their accounting into question. There are so many other cheap stocks without basic accounting concerns, so this one gets chopped as well.

3) Korn Ferry (KFY). Korn Ferry is cheap with a 17.5% earnings yield, but return on tangible capital at 27% is nothing special, and certainly shouldn't screen the stock into the top 50 (over 50 million). I've looked over the numbers numerous times on this one and cannot understand why it is an official MFI stock - there is little to misinterpret. Perhaps the data set is just wrong.

Replace With These "Unofficial" Picks

1) Incredimail (MAIL). At a nearly 40% MFI earnings yield and over 400% pre-tax return on tangible capital, how can MAIL not be screened? The stock has also consistently paid a monster dividend of about 15% for the past 3 years, although it suspended the dividend last November. It is an Israeli-based company, but so was MIND CTI (MNDO) and Cellcom Israel (CEL) when they were on the official screen. The company makes software to spruce up emails, has 55% of market cap in cash, and carries no debt.

2) Research in Motion (RIMM). RIMM has been in the official screen before, but is not today and hasn't been for some time. At an earnings yield of 35.5% and a return on capital number of 93%, it is, by far, the highest ranking stock with a market cap over $10 billion. It certainly should rank over official stocks like Dell (DELL) (16.1%; 85%) and Microsoft (MSFT) (15.1%; 133%). This one is a mystery.

3) Amtech (ASYS). MFI has a number of chip equipment stocks, but why not Amtech? My calculations show a earnings yield of 88.6% and return on capital of 94%, putting it above "official" competitors like LTX-Credence (LTXC) (27%; 103%) and KLA-Tencor (KLAC) (24%; 87%). Amtech is attractive, too, with a history of rapid growth, a stellar balance sheet ($60 million in cash with no debt), and trading near a 52-week low.

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Posted by gagahonk on 2011-08-29 13:04:48

Hi Steve - MAIL is pretty cheap looking (so cheap I actually bought some this afternoon), but note that MAIL signed an acquisition for $25 million (cash) plus an earn out for maybe another $15 million according to an early August press release I found when I was poking around on it. That's most of the cash they had on their balance sheet at the end of the last quarter, so query whether that has any impact on the dividend, etc. for the near-term while it's being determined if the acquisition works as forecast.

Thanks for this interesting post on MFI curiosities.

Posted by andrewsdad on 2011-08-30 08:47:23

I could have sworn I read a while back, at MG's blog?, that MAIL was going to stop the dividend. Was trying to find confirmation of that yesterday afternoon but so far have not found it.

ASYS baffles me. I have it in the MFI contest Marsh is running, currently down 48%. One of the few non dividend stocks I have. Am thinking of buying some next time I rotate stocks out of my real money MFI account.

Posted by Steve on 2011-08-30 10:28:22

Thanks for the comments everyone. A commenter on Seeking Alpha brought to my attention that MAIL did suspend the dividend, and indeed I found it in a 6-K filed last November. This information had not been updated to Yahoo or Google Finance yet. So I apologize for that. The article has been updated here on my site.

Posted by g_v_w on 2011-09-03 03:31:28

Impax (IPXL) could probably be removed from the MFI screen, unless Q3 is more than 3 times better than the past 3 quarters. The company remained on the screen because of exceptional earnings in Q3 2010.
For the moment, the company appears much less profitable.

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