At least that’s what hedge fund manager and value investing icon Joel Greenblatt says. In a series of books and lectures Greenblatt has touted his “magic formula” for stock picking. Greenblatt argues that by following the simple formula we can take the guess work out of picking bargain stocks.
So what is the magic formula?
I’m glad you asked. Simply put it’s the best ranked stocks with a low earnings yield and a high return on capital. The formula seeks to find cheap stocks that are performing well. And while that sounds overly simple, following this simple formula would’ve helped you trounce the market over many years.
I’ve looked through the best ranked stocks according to Greenblatt’s formula, and these three make the most compelling buys right now. Since return on capital and earnings yield aren’t easily available in most circles, I’ll reference “return on assets” and “P/E ratios,” which closely mirror the aforementioned metrics.
Fruitful profits
Typically, the stocks ranked best by the “magic formula” are small caps. Remember the formula looks for companies with great returns, not stocks that are simply cheap. Usually, large, well performing stocks that are highly visible don’t go unnoticed by Wall Street’s big boys. But that’s not the case for Apple Inc. (NASDAQ:AAPL).
Apple ranks amongst the best of all magic formula stocks with a P/E of 10 and return on assets of 22.95%. The stock also has a stunning return on equity of 33.45%, and both return metrics are much higher for Apple Inc. (NASDAQ:AAPL) than the industry average. It’s a stunningly low valuation for a company this large; recently Apple had the highest market cap of any company worldwide.
With several high-profile missteps and shrinking margins, investors are (reasonably) skeptical about Apple Inc. (NASDAQ:AAPL)’s growth prospects. I understand the skepticism, I’m worried too. But at this point, at these levels, Apple doesn’t need growth to be a good value. It’s time to stop worrying about Apple Inc. (NASDAQ:AAPL) being “the next Microsoft Corporation (NASDAQ:MSFT).” Now that the firm is buying back shares and has raised its dividend, it only needs to survive to reward shareholders.
It’s a reasonable bet, and I like Apple here.
The employment formula
A far less known yet just as cheap a play is DICE HOLDINGS, INC. (NYSE:DHX) . You may not know about Dice, but this company is a recruiter’s best friend. Dice’s products (specialized career websites, career fairs, etc.) help fill the hardest to fill positions. Hiring authorities, which are Dice’s customers, believe in the brand because DICE HOLDINGS, INC. (NYSE:DHX) only fills niche positions. For instance, one of Dice’s job boards, “Rigzone,” only helps recruiters find petroleum engineers. Considering the current unemployment rate for petroleum engineers is below 1%, you can understand why hiring managers keep DICE HOLDINGS, INC. (NYSE:DHX) sales reps on speed dial.
Dice’s stock has been held in the $8 range as their most recent quarter failed to beat EPS. That said, with the employment market bouncing back–particularly for skilled positions–DICE HOLDINGS, INC. (NYSE:DHX) could rally from here. The stock ranks amongst the top 50 “magic formula” stocks, with a P/E of 15 and a ROA of 11%. I think, in the wake of a so-so quarter, now is the time to roll the dice on this one.
The cheapest way to play the AgSuperBull
By the numbers, CF Industries Holdings, Inc. (NYSE:CF) is among the best values ranked by this formula. With a P/E of just 6, and return on assets north of 18%, no one can call this stock expensive.
So why is CF Industries Holdings, Inc. (NYSE:CF)’s stock price stuck? It’s not for performance — in addition to having excellent return on assets, CF Industries Holdings, Inc. (NYSE:CF) recently beat on earnings and EPS has grown a whopping 34% over the past five years.
My theory is that the market keeps trying to time the highs and lows in this nitrogen and phosphate fertilizer firm. CF Industries Holdings, Inc. (NYSE:CF) is part of a major growth trend that I fondly call the “AgSuperBull.” Much like Deere & Company (NYSE:DE) and Potash Corp./Saskatchewan (NYSE:POT), it has long-term growth trends but its price is sometimes hampered by speculators.
The stock is (obviously) linked to commodities, so it’ll always fluctuate based on how commodity traders view the near-term outlook. But to me, if you’re a long-term investor, this creates great buying opportunities. It seems beyond obvious that as the world population grows beyond 7 billion and growing conditions become harsher, large agriculture and fertilizer stocks will do well. So why not buy a little of this name now for the long haul, and buy more every time the speculators decide to try to predict the weather.
You should bet on this agriculture bull — if you’re in it for the long haul it’s a no brainer.
It’s ok to like a value
Everyone likes a value, but finding them doesn’t have to be so hard. What I like best about Joel Greenblatt’s “magic formula” is that it provides outstanding returns without making the process cumbersome. It cuts straight to the two most important aspects of buying a stock: the stock’s value and (business) performance.
But what it doesn’t do is make a smart decision for you; you’ll have to do that. In other words, it makes sense to start with the magic formula to screen stocks, but ultimately you’ll have to make the call on which stocks to buy.
I like these stocks because not only are they cheap with great past performance, they have a bright outlook going forward. Wouldn’t you agree?
The article These 3 Stocks are ‘Magical’ Values originally appeared on Fool.com.
Adem is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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