Magic Fomula Investing, as defined by joel Greenblatt's book 'The Little Book That Beats the Market', is all about automating the investment process and taking the guesswork out of the investment decision making process. Buying stocks with high returns on equity, with little debt and low PE ratios, is a sensible approach on the face of it. However, when the research is conducted, this strategy has proven to work in practice as well as in theory. This makes it a reliable investment alternative to holding index funds, mutual funds, or treasury bonds.
In my last article on Magic Formula stocks I discussed the larger cap names as I feel they are significantly less expensive than their smaller cap brethren. With that said, Greenblatt and others will likely argue that small cap value is the best place to be over the long term because smaller companies are usually out of the limelight enough that investors don't pay enough attention to the bargains that exist in the space. By buying small companies with high returns on equity, investors can mitigate some of the fraud, corporate governance, and agency conflict risks that arise in small cap below book value investing, which is another alpha generating strategy according to academic studies and real world results of investors in the space.
Currently, Hedgephone is slightly bearish on the stocks up the most since the crash of 2008-- provided the fundamentals don't support current valuations given the extreme rise in margin debt and stimulus measures that tend to be bullish for the short term but create asset price bubbles over the medium and longer term. Indices such as the Russell 2000 and many higher beta technology names appear to be quite stretched from a valuation as well as macro perspective, although we certainly respect and admire the ability of online companies to grow and prosper in today's marketplace.
Here are 20 Magic Formula stocks with market caps under 1.5 billion dollars to research further:
Almost Family (NASDAQ:AFAM) is a provider of home medical equipment and other home health related services. The company trades for 10.77X trailing earnings and for around 12X forward earnings. Almost Family also sports an EV/EBITDA ratio of less than 5X and an ROE of 16.7%. AFAM appears to be a good company at a reasonable price, while the company maintains strong market share in a recession proof and growing industry. These shares are down since the start of 2011, so investors might consider dollar cost averaging into the name on further weakness.
Cardiome Pharma Corp. (NASDAQ:CRME) shares look down right cheap at first glance, trading for a mere 8.76X earnings in a growth industry with a 116% return on equity and an EV/EBITDA of less than 7X. However, price to forward earnings is a little less exciting at 50X this year's earnings. The company has lost money in years past, and the recent surge in earnings should be examined closely as to whether the gains were of a one time nature or are a sustainable trend of strong growth. The company has many drugs for treating heart illnesses which appear to have solid prospects, making CRME a stock to watch.
ChinaNet Online Holdings (NASDAQ:CNET) is a magic formula name with some caveats as far as risks are concerned. Having watched China MediaExpress (OTCPK:CCME) become halted, and many other Chinese smallcaps fall by the wayside, there is no question that the sector carries added risk but also potential added rewards. CNET is trading for just 3.74X earnings and for less than 3X forward earnings. ROE of 69% seems a bit too good to be true, but is not totally unrealistic for an internet business. Investors may want to visit Alexa and check out CNET's www.28.com, but for now this is a stock that seems a bit too uncertain for me to invest in after watching the bloodbaths in Yongye (NASDAQ:YONG), CCME, HQ Sustainable Maritime (HQS), OTC:RINO, etc...
Jiangbo Pharmaceuticals (OTCPK:JGBO) is another dirt cheap Chinese Magic Formula name which is trading at 1.16X earnings. The obvious caveat is that so many of the small cap Chinese names have turned out to be complete and total frauds at this point. With that said, there are surely many companies worth buying in China and it is highly likely that several good companies are being painted with the fraud brush incorrectly and are selling for extreme discounts to intrinsic value (what we want in a stock pick). Without strong insider buying or share repurchases, I cannot recommend any of the 1-4X earnings Chinese names, as most-- if not all-- businesses trading for such a cheap valuation would simply buy back a ton of their own shares.
Mind C.T.I. (NASDAQ:MNDO) is an interesting idea at 13X earnings with a 20% return on equity. However, losses in years past would likely exclude the company from making it into the portfolio of Benjamin Graham. However, with Renaissance, T2 Partners, and Centaur Capital Partners as large owners of the stock, investors here are in good company on the long side of the name. If the company can earn a dollar per share again as it did in 2009, the stock could rise significantly from the current 3 handle and make investors some solid money.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.