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We recently combed through the stock market looking for ideas that score highly based on the Joel Greenblatt-style “magic formula” quantitative stock screening methodology (popularized in Greenblatt’s The Little Book That Beats The Market). The “magic formula” looks for companies that are both “cheap,” as measured by trailing operating income to enterprise value, and “good,” as measured by trailing operating income to capital employed in running the business. The goal, of course, is to pay a low price for companies that will reinvest capital at high rates of return.

Unlike Greenblatt’s original methodology, which took into account last twelve months’ EBIT only, we consider stocks that rank highly based on one or more of the following inputs: last twelve months’ EBIT, consensus EPS estimates for the current year, and consensus EPS estimates for next year. Since EPS numbers, unlike EBIT numbers, do not normalize for the effects of leverage, our forward EPS-based methodology only includes companies with modest or no net financial leverage.

The reason we keep coming back to the “magic formula” as a way of generating investment ideas is simple: It works. In fact, we are unaware of any other replicable, quantitative investment approach that has outperformed as impressively. Consider the following partial track record:

Magic Formula Performance vs. S&P 500 Index, 1999-2009 *

(%) ‘99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 CAGR

MF 16 9 36 -21 52 28 22 13 15 -36 46 14.5

SPY 15 -9 -12 -22 29 11 5 16 6 -37 19 -0.2

* MF data reflects performance of Formula Investing Model Portfolio, net of fees. 1999 data is from October 1, 1999 to December 31, 1999. 2009 data is through September 30, 2009. Past performance is no guarantee of future results.

Source: Formula Investing

It makes intuitive sense that an investment approach that focuses on paying relatively little for businesses that can deploy incremental capital at relatively high rates of return should work over time. There are other reasons why the “magic formula” has worked and appears likely to continue working in the future. One of those is that the companies that rank highly on “magic formula” criteria tend to have something obviously “wrong” with them. None other than Joel Greenblatt has discussed the difficulty of implementing a “magic formula”-based investment approach, despite the obvious long-term rewards. In a presentation at the Value Investing Congress last October, Greenblatt went down a list of “magic formula” companies, demonstrating that an investor would have a relatively easy time rejecting virtually all the companies on the list. A video of Greenblatt’s speech is available by clicking here. We highly recommend viewing Greenblatt’s speech.

With the appropriate caveats in mind, we present the following three “magic formula” companies for further consideration:

CA Technologies (NASDAQ:CA) is a software and IT solutions company that long-time investors may know better as Computer Associates, a company founded by Charles Wang with three employees in 1976 and grown through dozens of acquisitions. While Wang resigned amid controversy in 2000, the stock has not recovered even as revenue and profits have grown in recent years. CA has a defensible position in enterprise IT management software due to competitive products and a large installed base. The company’s software generally helps large organizations manage their disparate technology assets in order to improve business processes and lower costs. Although competition and technological change present challenges, the need for better utilization of technology infrastructure for business purposes should remain a long-term growth driver. With a consensus EPS estimate of $1.90 for the year ending March 2011, and earnings expected to keep growing, the stock appears quite cheap at roughly $19 per share.

Dell (NASDAQ:DELL) is expected to earn $1.28 per share in the fiscal year ending January 2011 and $1.44 per share in the year ending January 2012. These earnings expectations would make most companies trading at less than $13 per share worthy of closer consideration, but this is especially so in the case of this global technology brand with capable, properly incentivized management, a capital-light business model, and a net cash position of $7+ billion (more than 25% of recent market value). The company is addressing challenges in the consumer products business amid slowing growth and greater competition. Some have questioned Dell’s direct model, and the company has felt a need to partner with retailers to expand distribution. Nonetheless, we like Dell’s long term-oriented business approach, strong FCF generation, share buybacks, cost leadership, and prospects in enterprise/services markets. Accordingly, we are not surprised that Dell’s largest outside shareholder continues to be superinvestor Mason Hawkins’ Southeastern Asset Management, which owns 7% of the company.

Recovery audit specialist PRGX Global (NASDAQ:PRGX) has historically aided retailers in recovering overpayments resulting from complex purchasing processes and human error. More recently, the company has expanded into other verticals, especially health care. PRGX is also a subcontractor to CMS, the U.S. agency administering Medicare, with management expecting “meaningful” revenue related to Medicare to commence in the second half of this year. The company generated adjusted EBITDA of $27 million in 2009, yet trades at an enterprise value of roughly $120 million. We find this quite attractive given the low capital intensity of the business, recurring revenue characteristics, and sizable long-term growth prospects. One of the major conceptual risks is that PRGX could become a victim of its own success, i.e., clients’ need for PRGX services may diminish as the company assists clients in improving their payment processes. However, this risk may be a bit akin to the “paperless office,” which has failed to materialize despite a seemingly sound conceptual basis.

Author's Disclosure: No positions

Source: Three 'Magic Formula' Investment Prospects to Consider