24 Cheap Stocks With 'Magical' Momentum

by: Alan Brochstein, CFA

Though I believe that many of you will realize how late to the game I was, I also know that many of you will have no idea about the great investment book that I read this week, “The Little Book That Beats the Market” by Joel Greenblatt. When I launched my business late in Q1, a prospective client asked me to help him create some screens that would capture the essence of Greenblatt’s “Magic Formula”. He swore it was the best thing since sliced bread. I am here to tell you that though sliced bread is a bit better, it was a fantastic book. It took me three months to read, though the first 90 days I didn’t actually read it. After I spent the 90 minutes required to actually read it earlier this week, I ended up spending about four hours just thinking about how to apply the intuitive and simple but compelling concepts portrayed by Greenblatt.

Before I get to one of my Greenblatt-inspired screens that I created after reading about the “Magic Formula”, allow me to summarize the major points of the book. Greenblatt shares an investment strategy that is contrarian/value oriented, suggesting that beating the market is quite tough, but he has the proven model to do so. His goal is to buy “good companies at cheap prices”. He ranks the universe of stocks in a two-factor model. The first factor is Earnings Yield. While many define Earnings Yield as the inverse of the PE (1/PE), Greenblatt’s definition is somewhat different (EBIT/Enterprise Value). EBIT (Earnings before Interest and Taxes) is a measure of earnings. EV is the value of the market value of the stock plus the value of the debt less cash. The higher the EY, the better. The second factor is Return on Capital [ROC]. Again, Greenblatt’s definition is slightly different perhaps from the calculations of others: EBIT/(Net Working Capital + Net Fixed Assets). Again, the higher the better. The implementation of the Magic Formula is to hold 20 to 30 of these stocks that offer the best combined ranking based upon the two-factor model.

I decided to try to create my own magic universe, with the goal of then looking deeper into it to try to identify stocks with other favorable characteristics. For those stock-pickers who would like to access the top stocks as ranked by Greenblatt, you can visit his site. You will need to create a log-in and password. There is also a link to the book there ($13.57 at Amazon.com). I had a lot of questions about the formula, specifically how it dealt with intangible assets (ignoring them boosts the ROC and rewards highly acquisitive companies) and whether or not debt was rewarded by his formula for Earnings Yield. In any event, I created a universe using the top 600 names (20%) of the Russell 3000. For Earnings Yield, I used the trailing PE. For ROC, I used Net Income/Total Capital. I also created a universe in accordance with Greenblatt’s definitions. While there were some differences, the overlap was pretty high. In any event, I ended up with what I refer to as the “Magic 600”. In the screen that follows, I attempt to isolate from this list of cheap companies those that have earnings and price momentum. My premise is that if these stocks are “cheap” to begin with and performing well fundamentally and technically, there may still be significant upside. Using the following constraints, I ended up with 24 names that are worth investigating further:


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The criteria used to narrow the Magic 600 were stable or rising earnings estimates, Debt/Capital <40%, a limitation on how overbought the stock could be and strong relative performance over the past month and quarter. The resulting list included stocks from several sectors (Utilities and Financials are specifically excluded by Greenblatt, so I kicked out 4 Financials). The median stock has a market cap of just over $2 billion and only 6 analysts covering it. The median PE is 15.5, while the median PEG ratio is just 1.1. All of the stocks on the list are positive year-to-date, with a median return of almost 41%. Yowsa! Of these stocks, only MSC (NYSE:MSM) and Plexus (NASDAQ:PLXS) are members of my watchlist, but I am quite familiar with Men’s Warehouse (MW). Next week, I will share a different screen of the same Magic 600 that attempts to capture stocks that are rebounding as opposed to “off to the races” like these. Happy Hunting!

Disclosure: none