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Today, I want to pit two Magic Formula Investing® (MFI) gun stocks against one another: Smith & Wesson (SWHC) andSturm Ruger (RGR). What is behind the gun stocks' appearance in MFI? Do they look like attractive investments at current prices? Which of the two is better? Let's put them under the scope.

Boom, Boom, Boom

Like it or not, firearms are woven tightly into American history and culture. The founding fathers found gun ownership so important that they protected it in the second amendment to the U.S. constitution. Some of the world's most famous guns and gunmakers, from the Colt Single Action to theRemington 870 to the M16, have come from America. At about 40% personal ownership and over 300 million guns, the U.S. easily has the most armed citizenship in the world.

Recently, the gun industry has enjoyed record demand, with 3 distinct gun "booms" in the U.S. over the past 5 years. The first came in 2008, when the election of Barack Obama sparked fears of increased gun control and even a potential repeal of the second amendment. The second was in 2012, when his re-election became apparent. And the third, ongoing to this day, came after the horrifying school shooting in Newtown, Connecticut, sparked new momentum for gun control laws.

The tangible evidence is staggering. Background checks are up a staggering 4-fold since 1999. Since 2007, Ruger has grown sales 243% while Smith & Wesson is up 127%. Both firms are running flat-out, struggling to produce enough guns to meet demand.

Without a doubt, it has been a good time to be a gun maker.

Dueling Stocks

So we know the industry conditions are good, but which of the two stocks is more attractive?

The companies themselves are very similar. Ruger makes essentially all of its dough from firearms, and although S&W is also a big maker of handcuffs, 96% of sales are from guns. Both firms compete mainly in pistols, revolvers, and rifles. Ruger doesn't compete in black powder guns or "modern sporting rifles", where S&W does with its Thompson Center and M&P Sport lines, respectively.

From a quality standpoint, there is a clear winner - Ruger. While both have enjoyed the boom, Ruger has operated better. We already quoted growth figures, where Ruger has double the revenue growth since 2007. During that period, Ruger has successfully gotten in front of the trends, a notable one being lightweight compact revolvers, something Smith & Wesson was behind the curve on. Ruger has a better balance sheet, with $46 million in cash and zero debt, vs. $62 million cash / $44 million debt for S&W. Ruger's operating margins have been in the 16-23% range during the boom, while S&W's have been about half that. Return on invested capital for Ruger has averaged 63%; for Smith & Wesson, 19%. S&W also went through a debacle of buying security supply company Universal Safety Response in 2009, only to turn around and divest it in 2011! Clearly, Ruger has been a better operator.

From a value standpoint, though, the opposite is true. Smith & Wesson is a much cheaper stock, with a 9.3 P/E ratio and a 19% pre-tax earnings yield, vs. 13.0 and 12.6% for Ruger, respectively. New management at S&W is making real progress in operations, posting a 20.7% operating margin in the past 12 months, only a few points behind Ruger's 23%. One point in Ruger's favor is the dividend - that company pays a substantial 3.8% yield, compared to no dividend for Smith & Wesson.

Pull the Trigger?

If someone held a gun to my head and told me to pick one of the two for investment, my choice would be Smith & Wesson, at least at current prices. Ruger may be the better company, but S&W is the better investment. A cheap valuation is the best determinant of investment success, and SWHC is considerably cheaper. Also, S&W has the longer history (160 years) and better known brands, no small advantages in a market where the collector is a major factor. Finally, S&W simply has more room to improve, and new management is already getting the company back on track and catching up to Ruger's operating standard.

All this said, I'm still not convinced that current gun demand is sustainable over the long term. In coming up with valuations for these stocks, it is prudent to scale back to 2010-11 volumes when estimating future cash flows. Doing this, I come up with a target around $12 for S&W, and about $49 for Ruger, further supporting the case for Smith & Wesson. In any case, a 25% margin-of-safety on SWHC is a bit tight for what seems like a market in a bubble. Neither of these gun stocks looks interesting enough to enter our Top Buys list right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Magic Formula Investing (MFI), as described by hedge fund manager Joel Greenblatt inThe Little Book that Beats the Market, consists of ranking stocks by earnings yield (cheap) and return on capital (quality), adding the rankings together, and buying from the resulting lists. Below are stocks that have moved into, and dropped out of, 3 of the MFI screens used by MagicDiligence:

Entering the 50 over 50 million screen:

CF Industries Holdings Inc (CF)
Enzon Pharmaceuticals Inc (ENZN)
Express Inc (EXPR)
PetMed Express Inc (PETS)
Sturm Ruger & Co Inc. (RGR)
Smith & Wesson Holding Corp (SWHC)

Dropping out of the 50 over 50 million screen:

Auxilium Pharmaceuticals Inc (AUXL)
ClearOne Inc (CLRO)
Digimarc Corp (DMRC)
GT Advanced Technologies (GTAT)
SuperMedia Inc (SPMD)
Vonage Holdings Corp (VG)

Entering the 50 over 1 billion screen:

General Dynamics Corp (GD)
KLA-Tencor, Inc. (KLAC)
Meredith Corp (MDP)
Myriad Genetics Inc (MYGN)
NETGEAR Inc (NTGR)
Spirit Airlines Inc (SAVE)

Dropping out of the 50 over 1 billion screen:

C&J Energy Services Inc (CJES)
CVR Energy Inc (CVI)
Dun & Bradstreet Corp (The) (DNB)
Foster Wheeler Ltd (FWLT)
Western Refining Inc (WNR)
Weight Watchers International Inc. (WTW)

Entering the 30 over 3 billion screen:

Broadridge Financial Solutions Inc (BR)
General Dynamics Corp (GD)
KLA-Tencor, Inc. (KLAC)
Nu Skin Enterprises Inc. (NUS)

Dropping out of the 30 over 3 billion screen:

CVR Energy Inc (CVI)
Dun & Bradstreet Corp (The) (DNB)
Pitney Bowes Inc. (PBI)
Western Refining Inc (WNR)

Note: WTW is an actual MagicDiligence Top Buy recommendation! Learn about our service here!

Obesity is an epidemic in the United States and the trend has only been getting worse, more than doubling since the 1970's. In 2012, about two-thirds of Americans were considered overweight. This is not limited to the United States, either. In the past two decades, obesity rates across the world have skyrocketed by 82%. Overweight adults and children are at higher risk of developing diabetes, suffering a stroke, or getting heart disease.

Given the staggering growth in the overweight population, along with the associated health risks, the obesity epidemic is now considered a bigger global health crisis than hunger.

Such is the backdrop behind today's Top Buy pick, Weight Watchers (WTW). Weight Watchers is one of the most known and respected brands in the sometimes shady business of weight-loss solutions. Founded in 1963 by homemaker Jean Nidetch, the company has expanded into almost 30 countries and runs meetings attended by over a million people every week. The core of Weight Watchers is using a "points" system to simplify calorie counting. Members can participate through in-person meetings or through an online-only program utilizing mobile apps and (optionally) wearable activity monitors. Additionally, Weight Watchers licenses its brand to consumer products firms like Kraft (KRFT) and General Mills (GIS) and restaurants like Applebee's (DIN). Last year, meeting fees accounted for 51% of revenues (down 5.6% from 2011), Internet revenues were 27.6% (up 26.2%), in-meeting product sales (foods, points guides, magazines, etc.) accounted for 13.9% of sales (down 10.1%) and licensing and franchise royalties were 7.4% (down 8.9%).

I like Weight Watchers in the low $40's. This is a company that traded at nearly $80 a year ago and at $60 in early January. Recent operating weakness was largely attributed to advertising issues, a major one being the pregnancy of Jessica Simpson derailing a running campaign centered on her 50-pound weight loss on the system! Also, comparisons against 2011 were very difficult. 2011 was a record year, with 25-30% growth throughout.

No one should ever expect Weight Watchers to sustain 20%+ growth rates, and I certainly don't see the stock reaching the $80 point again any time soon. However, I do believe that marketing campaigns can be fixed relatively rapidly, and the tough comparisons will roll off later this year. Management did admit on the Q4 conference call that weak guidance could prove to be too conservative. Even assuming high single-digit declines this year, followed by modest 5% growth after that (driven mainly by Internet, international, and business-to-business growth), I see a 35% margin of safety at current prices.

That is pretty good for such a stable business. Meeting fees are recurring and have a very high rate of renewal. Meetings are the core of Weight Watchers' economic moat - it is a differentiator that few competitors have tried to replicate, and probably couldn't even if they tried. Brand is another - Weight Watchers is still the most well-known and respected brand in weight loss, a powerful advantage over new entrants or the latest fad. Even during the deep recession in 2008-09, Weight Watchers only experienced a 9% revenue decline and still maintained a respectable 25.7% operating margin. Cash flows are stable and reliable, and I categorize Weight Watchers as a "conservative" pick.

That's not to say there are not risks. Weight Watchers' growth is coming solely from Internet revenues, with meeting fees slowly declining for much of the past decade. This is an issue, because as stated before, the core of Weight Watchers' competitive advantage is its meeting infrastructure. There are loads of (often free) mobile apps that users can track calories and exercise with.

Also, the company has a poor balance sheet. At $2.4 billion, debt dwarfs the $70 million on the balance sheet. Fortunately, Weight Watchers' reliable cash flows are more than enough to handle it, and interest obligations are covered more than 5 times over by operating earnings. Banks don't seem too concerned either, as the firm recently refinanced its entire debt load, extending maturities and ultimately reducing interest payments. Still, should operational weakness worsen, the firm could be in danger of violating debt covenants, which would be a major issue, albeit unlikely (particularly within our one-year holding period).

All in all, Weight Watchers looks like a good investment opportunity at present, despite a few warts. The sell early target is $57.

Read MagicDiligence's Weight Watchers (WTW) Research Report