The Magic Formula Investing (MFI) strategy is simply a ranking system. Any particular universe of stocks can be ranked in the strategy's fashion - a composite of highest earnings yield and highest adjusted return on capital, both factors equally weighted. You can apply the strategy to rank any "basket" of stocks, ranging from entire exchange listings (or groups of exchange listings), to a pre-screened list of stocks, and so forth. The possibilities are limitless.
The official MFI site allows users to rank all U.S.-listed stocks, separated only by minimum market cap. So, for example, choosing the top 50 stocks with a minimum of $100 million market cap will produce a much different list than choosing the top 50 with a minimum $1 billion market cap. This is useful, as many investors are uncomfortable buying issues of thinly traded, micro-cap stocks that they may not be familiar with (even though small-caps drastically improve performance).
MagicDiligence uses three screens in particular to search for stocks to recommend: the top 50 stocks over $50 million market cap (the "small cap" screen), the top 50 over $1 billion ("mid cap"), and the top 30 over $3 billion ("large cap"). By combining the three, we get a good mix of cheap, quality stocks ranging from tiny unknown firms like database software maker Versant (VSNT) to ultra large caps like diversified software maker Microsoft (MSFT).
However, sticking to these three screens means that occasionally a few stocks will slip through the cracks. Setting out to find these, I ran several "in-between" screens: the top 50 over $250 million, top 50 over $500 million, top 50 over $750 million, top 50 over $2 billion, and finally, the top 30 over $5 billion market cap. While there were a number of in-between stocks (about 15 or so), this article will highlight three of them that may deserve additional attention from value investors.
Fuel Systems Solutions (FSYS)
Market Cap: $489 million
MFI Earnings Yield: 26.2%
MFI Return on Capital: 78.3%
Cash / Debt / Current Ratio: $74m / $17m / 2.06
5-year Expected Growth Rate: 16.3%
Dividend Yield: N/A
Piotroski Score: 7.0
Comments: Fuel Systems develops components and systems for controlling alternative fuels like natural gas and propane in internal combustion engines. Most sales are in the transportation business (autos, busses, taxis, specialized vehicles) outside of the U.S. In the short-term, company has been buoyed by now-expired tax credits in Italy, and 2010 expectations are down some from last year. Long-term though, the price, abundance, and relative cleanliness of natural gas vs. oil/gasoline could be a significant catalyst for this firm, in both the U.S. and abroad.
Career Education (CECO)
Market Cap: $2.2 billion
MFI Earnings Yield: 12.8%
MFI Return on Capital: 72.0%
Cash / Debt / Current Ratio: $422m / $2m / 1.33
5-year Expected Growth Rate: 12.4%
Dividend Yield: N/A
Piotroski Score: 8.0
Comments: Career Education is a for-profit education company, one of many in MFI (Apollo (APOL) and Corinthian Colleges (COCO) too). CECO has 90 campuses and over 116,000 students, including some foreign exposure in Europe. These are all great businesses heavily discounted due to fears that the government will institute much more strict standards for federal aid dollars, which usually makes up 80% or more of revenues for these firms. On the other hand, high unemployment has led to swelling enrollments, and the public colleges do not service the typical 30-year old, working student as well as these private players. The whole sector could be a good value play.
Quest Diagnostics (DGX)
Market Cap: $9.5 billion
MFI Earnings Yield: 10.8%
MFI Return on Capital: 106.4%
Cash / Debt / Current Ratio: $463m / $3B / 1.53
5-year Expected Growth Rate: 8.3%
Dividend Yield: 0.80%
Piotroski Score: 7.0
Comments: The largest independent diagnostic medical testing firm in the U.S., with over 2,000 locations. Duopoly with Lab Corp (LH, another on-again off-again MFI stock). Demographics is the story here - as the U.S. population ages and doctors push preventative care, increased clinical testing demand should follow. Quest has solid competitive positioning and fair growth prospects. Risks include a valuation that is not that cheap for an MFI stock and continued breakthroughs in point-of-care diagnostic testing. Still, this looks like an attractive, conservative play at current prices.
Disclosure: Steve owns COCO, APOL