17 Undervalued Magic Formula Stocks to Research

by: Hedgephone

In "The Little Book that Beats the Market," investment legend and billionaire Joel Greenblatt of Gotham Capital explains why his strategy of finding good businesses (ones with high returns on equity and little debt) at cheap valuations (stocks with low PE ratios or preferably low enterprise value to free cash flow ratios) have historically outperformed the overall markets to a large degree. In essence, he recommends buying stocks on his proprietary screen in a diversified basket of at least 30 names and holding them for a little over one full year. When this strategy is backtested and implemented in the real world, results have been quite impressive and market-beating. In fact, the Magic Formula Screen has beaten the major averages with a 30% theoretical return over the past 17 years, according to Wikepedia.

Greenblatt has been very generous with his fellow value investors and runs a free educational website, www.magicformulainvesting.com, where investors can research stocks that fit into his magic formula criteria for longer term investment holdings -- Greenblatt recommends holding the stocks on his list for one year. Below are 17 stocks that meet the magic formula's incredibly stringent criteria which have market capitalizations of over $2BN. These larger cap companies look like better values to me than some of the smaller cap names listed, as many of the smaller names have had incredible runs already and trade for a bit higher multiples than the large cap names in this screen and in the overall markets. When using the top 30 stock screen with a market cap of over $2BN, the following 17 candidates came up. To me, these names represent the most intriguing investment candidates on the Magic Fomula Screen at this time.

Microsoft (NASDAQ:MSFT) -- Microsoft is a favorite of Whitney Tilson and has made the Magic Formula list for stocks trading at over $2BN in market cap. Mister Softy is much despised by most tech investors who are betting on speculative companies with little to no earnings or book values and shorting "old tech" stocks like MSFT and Intel. MSFT trades for just 9X forward earnings, and investors looking to buy at a cheaper price should consider selling the january 2012 $25 puts for $2.10 or so per contract. Return on Equity at Microsoft is a whopping 44%, which makes this a top stock to own for 2011. An EV/EBITDA ratio of 6X makes MSFT a good investment for a long-term investor.

Cisco (NASDAQ:CSCO) -- Cisco is another "old tech" name that shows up on the list of over $2BN Magic Formula stocks. CSCO is trading for just 9.7X forward earnings and an EV/EBITDA ratio of 6.2X, making the stock statistically cheap on cash flows and earnings. A 17.3% return on equity means that Cisco is a "good" business with a cheap valuation, which is essentially what the Magic Formula Screen attempts to find.

General Dynamics (NYSE:GD) -- General Dynamics is a name which has been slaughtered over budget cut fears, but America's affinity for defense spending will likely continue to a large degree in the future. General Dynamics is trading for just 9.47X forward earnings and an EV/EBIDTA ratio of only 6.1X. General Dynamics commands a 20% plus return on equity, which qualifies this company as a good enough business for us to consider buying at current prices.

Harris Corporation (NYSE:HRS) -- Harris Corporation is another Defense stock which made the over $2 billion screen and appears cheap on earnings and cash flows. Although this company trades for over 10X forward and trailing earnings, the business has a strong ROE, low debt, and an EV/EBITDA ratio of only 6.22X. Revenue growth of 18% quarter over quarter appears attractive along with YOY quarterly earnings growth of over 8%, and this despite the feared cutbacks in government defense spending. This one qualifies as an "Iron Man" type play, and there is no likely end to reckless government defense spending in the future. With even the top generals in the US Army stating that our deficits are a large threat to national defense, it is ironic that most of the deficit spending goes toward military spending.

Lockheed Martin (NYSE:LMT) -- Lockheed Martin is the third defense name on the list which appears to be a solid investment, given the global instability and the U.S. Government's thirst for military spending. Lockheed is cheap by the numbers with a 9.7X trailing PE and a 9X forward PE ratio. With a 67% return on equity and a quarterly earnings growth rate of 19%, LMT shares are proving that defense spending is a recession-resistant as well as a high margin business. In fact, trailing twelve month net profit margins stand at nearly 7%, which does not hit the 10% threshold for a truly "good" company to own, but is very close on margins and certainly attractive from a PE and ROE perspective.

Sandisk (SNDK) -- Sandisk is a relatively cheap stock on the Magic Formula list, trading for a low 9X trailing earnings and 11X forward earnings. The stock is fetching around 6X EV/EBITDA and offers investors a nice 26% return on common equity.

Dell (NASDAQ:DELL) -- Dell is another larger cap Magic Formula buy which looks dirt cheap at 9X earnings, with Michael Dell betting $150MM on his own company at prices not too much lower than the the current price per share. Dell is a cheap name at 4.5X EV/EBITDA, and it is nice to see the CEO eat his own cooking at this company. Investors looking to play this with options can sell the January 2012 $15 put options for $1.40 per contract for an approximate 1% per month return if the stock stays above $15 at expiration.

Aeropostale (NYSE:ARO) -- Aeropostale shares look fairly cheap with an incredible 53% return on equity and an EV/EBITDA ratio of just 4X. Shares are trading for 9.8X forward earnings with a PEG ratio of only . 9X. Price to Book value is a bit high at 5X, which partially explains the high return on equity, however, the stock is down almost 20% over the past year, while the S&P 500 is up over 10.6% over the same time period, which may mean that it is time for ARO shares to finally reach bottom. At 10.3X trailing earnings, the company looks reasonably priced for a longer-term investment.

AOL (NYSE:AOL) -- Aol shares look interesting at under 2X EV/EBITDA. The company is expected to earn money this year, and analysts peg the forward PE at a little over 16X earnings. Management has been deleveraging the balance sheet, while the company has ample cash flow to repurchase shares once this debt repayment process comes to a conclusion. With a price to free cash flow ratio of around 5X, AOL shares look reasonable from a cash flow statement perspective and the company trades for a slight discount to book (although for a significant premium to tangible book value, which I view as a more important figure). Once I took a second look at AOL, I decided sell 10 January 2012 $20 put options on AOL stock for $2.30 per contract. The stock is currently trading at $19.72 per share.

Intel (NASDAQ:INTC) -- Intel shares are favorite of mine these days for a number of reasons, but being on the Magic Formula list of stocks with $2BN plus market caps is certainly one of them at this point. The business is still trading for a reasonable 10.93X trailing earnings with a forward PE ratio of only 9.19, with a return on equity of 25%, which makes Intel a "good" company at a cheap valuation.

Marvel Technology (NASDAQ:MRVL) -- Marvel Technologies is a drive and chip storage company which is likely being punished by the market over the fears surrounding cloud computing technologies. With that said, the company maintains a strong competitive position with a 9.8X forward earnings multiple and a PEG ratio of only .70. With an EV/EBITDA ratio of only 6.5X and a return on equity of 18%, MRVL is a good candidate to own after a 28% drop in price over the last year. Revenue growth of 7% along with YOY earnings growth of 8% make Marvel an interesting choice on this list.

Hewlett Packard (NYSE:HPQ) -- Hewlett Packard has been taking it on the chin recently, but at 7X forward earnings, the company's shares appear to be undervalued and make the over $2BN Magic Formula screen due to the company's high quality business fundamentals, such as a 21% return on equity and a .81 PEG ratio. HPQ has the market for inexpensive laptops nearly cornered with its main value priced competition being DELL. Hewlett shares are currently hated on The Street, which may mean that it's time to buy this out of favor value stock.

Apollo Group (NASDAQ:APOL) -- Apollo Group is a stock that once commanded a huge PE ratio and a chart that only went in one direction -- up. Today, the shares have suffered due to the government crackdown in the paid for online college space that has made shares of Devry and Corinthian crash in sympathy. APOL is fairly cheap on earnings at 12.2X forward earnings, but very cheap on a cash flow basis at 3.2X EV/EBITDA.

Teradyne (NYSE:TER) -- Teradyne is a provider of Silicon Wafer and Semiconductor automatic testing equipment products. The company's shares are cheap at 5.2X EV/EBITDA and with a PE of around 10X trailing earnings and 9X forward earnings. Cloud computing is likely a worry for most of the chip makers, which is likely providing headwinds for TER common stock. That said, the company boasts an incredible 42% return on equity and quarterly revenue growth of over 20% year over year. Quarterly earnings growth of 225% should be tempered by the fact that the business was not profitable in 2008 or 2009, but cash flow from operations was positive during the past few years, which may mean that TER is a strong turnaround candidate.

Gamestop (NYSE:GME) -- Gamestop is a controversial business as the move to online gaming has hurt the share price in the short run. Interestingly enough, GME has been able to grow online revenues at a high enough pace to more than offset sluggish retail store revenue growth so that such a transition may not hurt the company as much as most analysts believe. GME appears undervalued at 9.9X trailing earnings and 8.28X forward earnings. EV/EBITDA is only 3.9X, which appears pretty reasonable compared to most of the bubble names trading for over 100X EV/EBITDA these days that all of the growth investors have fallen in love with.

The Gap (NYSE:GPS) -- The Gap still makes great jeans and nice shirts, but the stock is on sale at the moment, trading for only 4.7X EV/EBITDA and 10.7X forward earnings estimates. The Gap is one of the only brick and mortar clothing retailers on the list aside from ARO, and may be a good play on a rebounding clothing consumer. With that said, the future of consumerism is always being questioned, which is likely why the stock has dramatically underperformed the overall stock market over the past year, falling 15% while the S&P 500 has risen by 10.65% over the same time period.

Lender Processing Services (NYSE:LPS) -- Lender Processing Services appears dirt cheap at 8.72X trailing earnings and 6.8X forward earnings, but the business is likely facing headwinds because of their industry outlook. With a PEG ratio of only .67, LPS looks like a steal at current prices, after a 28% drop in share price over the past year. The company has responded by repurchasing $245MM of its common stock in 2010, which is surely bullish for a growing company trading at only 7X free cash flows.

Disclosure: I am long AOL, INTC, MSFT, DELL, LPS, TER, MRVL, CSCO, HPQ.