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Warren Buffett is the name generally discussed by value investors as the pinnacle of investment success, but value investors have heroes other than Buffett that deserve equal attention, such as Joel Greenblatt. In 1985, while serving as the chairman of the board for Alliant Techsystems, Greenblatt founded the hedge fund Gotham Asset Management with $7 million. While managing Gotham he became famous for his generic-titled "Magic Formula". The idea of this formula was to create a quantitative investment strategy for picking stocks. The formula was made public in his best seller "The Little Book that Beats the Market", published in 2005 (after he had already millions with his strategy). The Magic Formula produced returns of 30.8% from 1988 to 2004, beating the S&P 500's return of 12.4%.

Greenblatt's Magic Formula

His formula is not a valuation formula, but more of a stock screener. This screener ranks stocks from 1 to 50 with 1 being the most attractive stock and can be accessed for free on a website supported by Greenblatt.

His first step is to exclude:

  • All companies with a Market Cap less than $50 million
  • All companies in the Financial and Utilities sectors
  • All foreign companies.

The next step is to determine the remaining company's Earnings Yield and Return on Capital:

  • Earnings Yield = EBITDA / Enterprise Value.
  • Return on Capital = EBITDA / [Fixed Assets + (Total Current Assets - Total Current Liabilities)].

Rank the remaining companies by highest earnings yield and highest return on capital. The rank order will be determined by:

  • Add the earnings yield and return on capital together for each company.
  • Sort by highest to lowest.
  • Assign a numerical value to the top 50 companies. 1 will represent the top company, then 2, and so on.
  • All remaining companies, including the excluded companies from the first step, do not receive a number.

Current Ideas

At ValueMyStock we built a Greenblatt screener and supercharged it by applying our proprietary Valuator tool to his results and eliminating anything that appears to be overvalued, creating a robust list that uncovers some true value gems. These three companies are worth looking into, as these both pass the Valuator and make it into our Greenblatt list:

CA Technologies (CA) offers mainframe database management, enterprise service solutions and customer support services in the Software industry. In addition to being the top-ranked company in our Greenblatt list, Valuator returns a target price of $36.36 for a 32% margin of safety. I used Citrix Systems, Inc. (CTXS), Symantec Corporation (SYMC), Oracle Corporation (ORCL), and International Business Machines Corporation (IBM) as comparable companies. They also pay a 4.10% dividend yield and have beaten earnings estimates for four straight quarters. Second quarter earnings come out on October 25th, so watch for movement with this company.

Bridgepoint Education, Inc. (BPI) provides post-secondary education services, offering associates, bachelors, masters, and doctoral programs on physical campuses and online. Ranking third in our Greenblatt list, Bridgepoint passes the Valuator with a target price of $19.86 for a 51% margin of safety. Comparables selected are Capella Education Co. (CPLA), ITT Educational Services Inc. (ESI), Strayer Education Inc. (STRA), and DeVry, Inc. (DV). The stock is beaten down at the moment due to an impending investigation by the U.S. Justice Department for its compensation structure, sending the stock from $21.97 to $8.43 in July. If the investigation goes in favor of Bridgepoint, or results in an immaterial judgment, expect the share price to climb back towards the $20 mark.

ConocoPhillips (COP), the major oil and natural gas explorer, refiner and marketer, is a surprise find in the list. Conoco ranks 36th in our Greenblatt list and according to Valuator has a target price of $104.26 for a 46% margin of safety. I choose BP plc (BP), Exxon Mobil Corporation (XOM), Marathon Petroleum Corporation (MPC) and Hess Corporation (HES) for my comparable basket. Conoco pays a hefty 4.7% dividend yield and the refining operation stands to gain from a South Texas drilling boom, providing cheaper (and better) oil than the heavy Arabian crude America has been refining for the past decade. Earnings are being released today, so watch for a chance to make a move.

On the watch list: Northrop Grumman Corporation (NOC) makes the Greenblatt list but barely fails the Valuator. Using General Dynamics Corp. (GD), The Boeing Company (BA), Lockheed Martin Corporation (LMT) and Raytheon Co. (RTN) as comparables, I have a target price of $88.40 for a 21% margin of safety. I require at least a 30% margin for a stock to be a value-buy, but with an election looming and possible changes to the military budget, expect this stock to have movement. Downward movement to $62 or lower should trigger a buy.

Source: 3 Undervalued Companies That Meet Joel Greenblatt's Criteria