Magic Formula Investing (MFI) is probably most popular for digging up attractively priced and quality small-cap stocks that have been overlooked or misunderstood by the market. Small-caps are usually not covered by a lot of analysts and not talked about on CNBC, yet small-cap value has been the best performing equity group historically.
The book behind MFI, Joel Greenblatt's The Little Book that Beats the Market, confirms that this group also performs better using the strategy's principles. While the book's analysis showed the top MFI stocks of any size outperforming the S&P 500 by 18.5% annually, limiting to just the largest 1,000 stocks reduced outperformance to 11.2% annually.
While that is a significant drop, it is still an outstanding performance. There are clearly reasons why some investors prefer to stick to large-cap companies in their equity portfolios. For one, these stocks are more familiar to investors, making them easier to understand. Large companies also (usually) have much wider product lines, better economies of scale, long operating histories, diverse customer bases, and easy access to the credit markets, all of which most small-caps cannot boast. Additionally, large-caps usually have less volatile up-and-down price swings, which can be unnerving to inexperienced investors. Many people feel more comfortable investing in large companies because of these advantages.
With that in mind, MFI is an excellent tool for finding high quality, cheap big companies that could be attractive opportunities. MagicDiligence uses three screens when looking for Top Buy picks: the top 50 over 50 million market cap, top 50 over 1 billion, and top 30 over 3 billion. For this exercise, I've pulled the largest-cap screen available on the official site: the top 50 stocks over 5 billion market cap. Here are 5 stocks from it that MagicDiligence believes may meet the "investment trinity" of growth potential, competitive advantages, and financial health:
1) General Mills (NYSE:GIS):
MFI Earnings Yield: 9.9%
MFI-adjusted Return on Capital: 58.0%
Dividend Yield: 2.9%
General Mills is one of the best-known branded food makers in the world, with over 150 years of operating history and some of the most popular consumer brands including Cheerios, Betty Crocker, Pillsbury, and Haagen-Dazs. These brands give the company a solid competitive advantage, allowing them to price higher than competitors. Growth will come from a joint venture with Nestle (OTCPK:NSRGY) to expand internationally, which now constitutes just under a quarter of sales, as well as falling input costs. GIS has consistently outperformed the S&P 500 (by 13.4% over the past decade). With steady growth in both earnings and the dividend, the current valuation it makes an excellent conservative, long-term play.
2) Clorox (NYSE:CLX):
MFI Earnings Yield: 8.6%
MFI-adjusted Return on Capital: 50.5%
Dividend Yield: 3.3%
Clorox is a lot like General Mills. It is another well-known consumer products company with a 100+ year operating history, the type of firm that Warren Buffett covets. CLX is in the household products business, with brands like Clorox, Glad trash bags, Kingsford charcoal, and others. It has leading brands in 11 of its 15 categories. The growth strategy here is both international expansion plus new products that leverage their well-known brands (like Clorox wipes, for example). Growth should continue to be modest but steady, the company pays a solid dividend that has gone up each of the last 31 years, and the quality of their brands is a fantastic competitive advantage.
3) Philip Morris International (NYSE:PM):
MFI Earnings Yield: 11.5%
MFI-adjusted Return on Capital: 113.1%
Dividend Yield: 5.1%
I've written a lot about cigarette companies recently (Vector Group (NYSE:VGR) and Reynolds (NYSE:RAI) in particular), but PM might be the most attractive of them all. PM is the international spin-off of Altria Group's (NYSE:MO) popular cigarette brands, particularly Marlboro. This frees PM from the onerous regulatory environment in the United States, and also allows the firm to pursue growth in overseas markets. Tack this growth potential onto the other attractive aspects of tobacco companies - a sticky and brand-sensitive product, great cash flows, large and increasing dividend yields – and it makes an interesting investment prospect.
4) Expedia (NASDAQ:EXPE):
MFI Earnings Yield: 7.1%
MFI-adjusted Return on Capital: 197.0%
Dividend Yield: N/A
Expedia is the largest online travel company, providing booking and trip packages that tie together hotel rooms, airline tickets, rental cars, and so forth. This is still a rapidly growing industry, and Expedia should be able to drive 10-15% revenue growth for the next several years. The company's scale gives it significant advantages over competitors, as Expedia can more reliably and quickly sell seats and rooms for service providers. Growth and competitive position is solid. On the down side, the balance sheet is in decent, not great, shape, and the earnings yield is not as high as most MFI stocks.
5) Apple (NASDAQ:AAPL):
MFI Earnings Yield: 6.4%
MFI-adjusted Return on Capital: 51.0%
Dividend Yield: N/A
Believe it or not, Apple, the celebrated maker of Macintosh computers, iPod digital media players, and iPhone mobile phones, is somehow cheap enough to be screened by MFI. This is a company that has been growing sales and earnings at 35% and 88% annual rates for the past 5 years, respectively, with the breakout success of the iPod driving users towards Mac computers, and allowing the company to expand into mobile phones. With over 150,000 applications available for the iPhone, orders of magnitude above any competitors, Apple is well positioned to continue growing for the foreseeable future. New products like the forthcoming iPad should continue the trend. The risks here include a not-really-that-cheap stock price and the company's dependence on CEO Steve Jobs, whose health has been a concern over the past 5 years.
Disclosure: Steve owns no position in any stocks discussed in this article.