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Using Magic Formula Investing to Find Good Investment Sectors

As a value investing screen, Magic Formula Investing (MFI) can also be useful in highlighting what sectors of the market are out-of-favor right now. In several years of intensely following the MFI screens, one constant theme is that stocks in the same or closely related industries tend to enter and exit the screen together. This makes sense, as current and expected future macro-economic conditions around an industry are a major factor in the valuations of their components.

Often you see many of the major players within a sector show up at once. For example, all three major pharmaceutical distributors: McKesson (MCK), AmerisourceBergen (ABC), and Cardinal Health (CAH) all appeared in MFI together. More recently, most of the major for-profit education stocks are either currently in or have recently appeared in the MFI screens, including Apollo Group (APOL), Corinthian Colleges (COCO), ITT (ESI), and Career Education (CECO). For these stocks, bad press, government rumblings, and famous hedge fund managers have all hurt their valuations.

The way MFI is designed perpetually favors many industries. One that comes to mind are defense contractors, which have historically been assigned low P/E multiples. On the other hand, these firms usually have strong balance sheets and excellent competitive positions that keep returns on capital high.

With this in mind, let's look at 3 sectors that are heavily represented in MFI at the moment and comment briefly on each. Are there fundamental problems with the sectors, are they at a favorable portion of the business cycle, or are they just out-of-favor in the market? I used two screens, the top 50 over 50 million and the top 50 over 1 billion, to generate this report.

Consumer Retail (14 stocks)

Names here include store chains like Kirkland's (KIRK) and Gamestop (GME), to consumer retail goods makers like Reynolds American (RAI) and Decker's Outdoor (DECK).

In truth, this sector could be farther broken down. For example, all three major domestic tobacco companies are currently in the screens, for different reasons than, say, the number of casual apparel chains. Tobacco companies are generally low multiple stocks, facing secularly declining cigarette volumes in the United States, ever more onerous public health laws, and never-ending litigation. On the other hand, they also have strong brands, an addictive product, huge free cash flows, and pay very good dividends.

Most of the retail apparel stores and consumer goods producers are weak on a cyclical basis, though. May and June retail sales were mediocre at best, projections for the next few months are poor, and trailing returns on capital are high due to strong consumer demand over the past 9 months or so. Now may be a good time to play the consumer cycle and get in on these stocks. One very nice thing about MFI is that, by using enterprise value instead of market cap, only the consumer stocks with the strongest balance sheets make it into the screen.

Pharmaceuticals (16 stocks)

Drug stocks in MFI can be broken into two groups. The first group consists of companies with established drug portfolios. Examples here would include Endo Pharmaceuticals (ENDP) and Medicis Pharmaceuticals (MRX). The second group consists of small, development-stage drug development companies like Cytokinetics (CYTK) and several others.

For the former, short-term monopolies (via patent protection) give the established drug companies strong returns on capital. The second component of MFI, a low valuation, usually comes with concerns over looming patent expirations or generic challenges. For example, while Endo, with their drugs Lidoderm and Opana, is fantastically profitable (over 25% operating margins), both of these drugs face generic patent challenges that are ongoing. Unfavorable outcomes would have a drastic effect on business results. This fear keeps the earnings multiples low. However, in most cases generic challenges are settled in a manner which allows both the original drug developer and the generic challenger to profit handsomely. The established drug companies are usually a pretty good place to go hunting for Magic Formula ideas.

The development-stage drug companies are much riskier. Usually they appear in MFI due to a one-time milestone payment from a larger partner company. In some cases (like Synta SNTA), the one-time event is a cancellation payment on the most promising drug! On the other hand, a development company like Cytokinetics actually does have a promising drug and a strong partner in Amgen (AMGN). Tread carefully here, and do a lot of research before blindly buying one of these companies.

Technology (11 stocks)

Believe it or not, the tech sector is a pretty frequent visitor to MFI, and one of MagicDiligence's favorite areas to look for ideas. The "good" tech companies that make it into MFI usually have strong balance sheets, excellent cash flows, and solid growth prospects. The cyclical nature of the sector sometimes means that these stocks show up during a short-term downswing in valuation, a great time to buy them.

Many high growth industries are represented by tech-oriented Magic Formula stocks. The explosion of the mobile internet can be played with DragonWave (DRWI) or Research in Motion (RIMM). The strength of flash oriented mobile devices is an underlying driver for MFI stock SanDisk (SNDK). Cloud computing and the proliferation of digital media is a boon to the disk drive makers, of which the two largest (Seagate (STX) and Western Digital (WDC)) are both in MFI.

Magic Formula Investing can act as a nice "industry filter", finding you the most profitable business industries and then alerting you when the best players have gotten too cheap.

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