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Magic Formula Investing (MFI) looks for stocks with low valuations (measured by high earnings yield) of excellent companies (measured by high returns on tangible capital). So it is no surprise that the formula is in love with the for-profit education sector. These historically high margin, high growth businesses have come under mortar fire from Congress and the Department of Education (DoE) over the past year over low student loan repayment and high dropout rates, with several potentially game changing regulatory proposals looming over them. In these conditions, stock valuations have plummeted and practically the entire sector has shown up in MFI at some time or another. Currently, the screens select a total of 6 for-profits: Apollo Group (APOL), Capella (CPLA), ITT (ESI), Career Education (CECO), DeVry (DV), and the one I want to look at today, Strayer Education (STRA).

Strayer is one of the smaller players in this business, with just 89 campuses in 21 states and D.C., and roughly 56,000 students. Compare that to Apollo Group (University of Phoenix) with about 405,000 students! The company's primary geography is in the mid-Atlantic states and the south. Strayer focuses on working adults looking to build on their prior education by offering most classes in the evenings or weekends, and online.

A key differentiator here is that the vast majority of Strayer's students (81%) are working towards 4-year bachelor or master's degrees. Many competitors in this space are focused on trade-based disciplines or 2-year associates degrees. In general, bachelor and master students are more likely to pay back their loans, more likely to stick with the program and not drop out, and are more profitable to the company. As an example of their desirability, Apollo Group recently switched strategy to try to drive increases in their higher level degrees after years of "churning and burning" associates students through Axia College (to a sub-10% graduation rate).

A discussion of these stocks has to begin with the headline risks facing them. The federal government's Title IV loan program accounts for the vast majority of sales at these firms. One rule in place for limiting the amount of student loans is called the "90/10" rule. Basically, it states that a proprietary (i.e., for-profit) educator cannot derive more than 90% of cash sales from the federal government for 2 consecutive years. If it fails, that company becomes ineligible for Title IV funds for two years - a virtual death sentence for any for-profit firm.

Strayer is in great shape here compared to peers. In 2008, the company derived only 77% of revenue from Title IV, and 78% in 2009. To put that in perspective, Apollo's percentages were 85% and 83%, respectively. 90/10 compliance does not seem to be huge risk.

The second risk is the "cohort default rate", basically the percentage of students who default on their loans after a 3-year period. If an institution exceeds a 25% default rate for 3 consecutive years, it could lose eligibility to participate in federal grant programs. Here again, Strayer is sitting pretty. For fiscal 2006-2008 (the three most recent years with data), Strayer's rate was 10.5%, 13%, and 14%. That's well under the threshold and much better than the proprietary school averages of 18.8%, 21.2%, and 25%.

Finally are the proposed "gainful employment" regulations. Under the proposed rule, schools where less than 35% of students are repaying the principal on federal education loans would essentially become ineligible for federal loans. Schools with 35-45% would face restrictions on their ability to receive these loans.

Last August, the Department of Education released preliminary data that showed Strayer falling well below the threshold, at 25%. This was shocking considering the general consensus of Strayer as a quality institution, and was one of the lowest of any of the publicly traded for-profits.

While gainful employment remains a risk, the rule has come under fire from many sides, including minority advocacy groups (Strayer's student population is 74% minorities) and even 100 lawmakers. I believe the rule, or at the very least the calculation of repayment rates, faces drastic changes before having any chance of becoming law.

These risks aside, Strayer is clearly one of the top choices in the space. With operations in only 21 states, there is plenty of room for growth, with the firm opening 8-12 new campuses a year. Compound growth in revenues and operating profits has averaged about 20% annually since current management took over in 2001. Management has been generous in returning capital to shareholders, with a 3.3% dividend yield and an average 2.5% decline in share count annually since 2006. Possibly most important of all, Stayer has an excellent reputation with accreditation bodies and many corporate partnerships with large firms including General Dynamics (GD) and Verizon (VZ).

So, is Strayer a good Magic Formula pick? I think it is. The next few years will be difficult as new rules are imposed, for-profit companies work through the bad press over the past year, and the economy improves (enrollment is counter-cyclical). Strayer is experiencing 20% declines in new enrollment growth, but this should level off. My fair value estimate is $165, about a 39% upside from current prices. I have a positive rating.

As for Strayer against its competitors, it depends on your appetite for risk. At a 13.5% earnings yield, Strayer is not as cheap as Apollo (27%), ITT (24%), or Career Education (20%). On the other hand, it doesn't face as great a risk on 90/10 and cohort default rates. For risk takers, there is probably greater upside in these other names. For conservative types, Strayer still offers solid upside with somewhat lower risk.

Disclosure: Steve owns APOL

Magic Formula Investing, or MFI, is based on a process, not on hard limits. The process is simply applied on a "basket" of stocks, producing a relative ranking for each stock in that basket based on a composite of earnings yield and adjusted return on capital. The result you get is your basket ranked from 1-N, with lower rankings indicating good companies selling at cheap prices.

The strategy on a whole is usually applied to all U.S.-listed stocks over $50 million market cap, to find the market's most attractive "quality-at-value" opportunities. However, it doesn't have to be used in this manner. It is perfectly viable to apply MFI's tenets to smaller baskets of stocks to compare investment opportunities.

In fact, using MFI buys you a lot of advantages over more traditional price-to-earnings (P/E) and return on equity comparisons:

1) MFI uses enterprise value instead of market capitalization when calculating the earnings yield. This has the effect of penalizing firms with a lot of debt, while at the same time rewarding firms with a lot of cash on the balance sheet.

2) MFI uses operating earnings instead of net earnings when calculating the earnings yield. This eliminates the one-time charges that can distort P/E ratios, and also ignores the effects of unpredictable (and often non-recurring) tax provisions.

3) By using return on *tangible* capital (i.e., subtracting goodwill and intangible assets), and removing excess cash, MFI is comparing most firms on an apples-to-apples basis, instead of relying on some purely accounting assumptions for the value of assets.

With this in mind, let's look at a few examples of using MFI to compare investment opportunities. All of these examples were generated with MagicDiligence's Portfolio Stats Calculator.

Case #1: The "Pepsi Challenge" (PEP vs. KO vs. DPS)

Let's start with a very simple comparison: the three major soda pop makers. Which one of Coke, Pepsi, or Dr. Pepper is the best balance of high returns on capital combined with a low stock price? Taste was not considered:

Ticker	Company	Price	Quarter	EY	MFI-ROIC	CR	Rank
DPS	Dr Pepper Snapple Group, Inc.	$38.86	2010-12-31	8.9%	45.3%	0.98	1
PEP	PepsiCo Inc.	$67.14	2010-12-31	6.3%	30.8%	1.11	2
KO	The Coca-Cola Company	$67.50	2010-12-31	4.8%	25.0%	1.17	3

Dr. Pepper Snapple Group wins pretty handily, taking both the highest earnings yield and highest returns on capital. PepsiCo slots in second, and Coca-Cola comes in last with both the lowest earnings yield and returns on capital. The "CR" column is current ratio, a measure of financial health. Higher values are better - usually we like to see 1.0 and up.

Case #2: Large Department Store Retailers

Using MFI stats on competitors in a certain industry is useful on a larger scale too. While there are really only 3 major soda makers, there are several large department store retailers. Say you wanted to add some retail to your portfolio, but are unsure of which stock(s) to add? Let's take a look at a bunch of them, ranked in the MFI manner:

Ticker	Company	Price	Quarter	EY	MFI-ROIC	CR	Rank
KSS	Kohls Corporation	$52.06	2011-01-31	12.2%	21.8%	2.08	1
M	Macy's Inc.	$23.87	2011-01-31	11.9%	18.9%	1.36	2
WMT	Wal-Mart Stores, Inc.	$53.29	2011-01-31	10.3%	21.7%	0.89	3
TGT	Target Corporation	$49.73	2011-01-31	10.4%	16.4%	1.71	4
JCP	J.C. Penney Company Inc.	$37.33	2011-01-31	8.9%	10.7%	2.41	5
DDS	Dillards Inc.	$44.95	2011-01-31	9.4%	10.4%	2.05	6
SKS	Saks Incorporated	$11.40	2011-01-31	4.9%	6.5%	2.20	7
SHLD	Sears Holdings Corporation	$82.29	2011-01-31	3.8%	3.8%	1.34	8

A few things stand out here. One, most of the large retailers look pretty cheap, with earnings yields of 9% or higher (you can compare earnings yield to a bond or CD). Second, this industry is not particularly capital efficient, with returns on tangible capital in the 10-20% range. Most "official" Magic Formula stocks boast 50% or higher.

In this group, Kohl's wins the outright crown, with the cheapest stock price and most efficient operations. The middle is pretty bunched up, and lastly Sachs and especially Sears bringing up the rear. Prospective investors would have to justify Sears' weak profitability and fairly high valuation - is Eddie Lampert's name really worth it?

Case #3: The Dow 30

The method can also be applied to the popular indexes. To keep the example simple, we'll use the smallest of them, the 30 Dow Industrial stocks. Here they are in ranked order:

Ticker	Company	Price	Quarter	EY	MFI-ROIC	CR	Rank
MSFT	Microsoft Corporation	$25.52	2010-12-31	13.7%	137.9%	2.46	1
INTC	Intel Corporation	$21.46	2010-12-31	14.5%	47.9%	3.39	2
HPQ	Hewlett Packard Co.	$40.92	2011-01-31	12.8%	51.3%	1.18	3
CSCO	Cisco Systems, Inc.	$16.95	2011-01-31	11.4%	64.7%	2.81	4
MMM	3M Company	$93.98	2010-12-31	8.6%	48.4%	2.01	5
PFE	Pfizer Inc.	$19.94	2010-12-31	9.7%	40.2%	2.11	6
UTX	United Technologies Corporation	$86.82	2010-12-31	8.3%	47.1%	1.33	7
WMT	Wal-Mart Stores, Inc.	$53.29	2011-01-31	10.3%	21.7%	0.89	8
CVX	Chevron Corporation	$106.76	2010-12-31	11.5%	17.8%	1.68	9
IBM	International Business Machines Corporation	$168.30	2010-12-31	7.5%	41.1%	1.19	10
PG	Procter & Gamble Co.	$62.98	2010-12-31	6.9%	44.1%	0.80	11
MCD	McDonald's Corporation	$76.63	2010-12-31	7.9%	29.2%	1.49	12
GE	General Electric Company	$20.10	2010-12-31	13.6%	13.3%	3.01	13
XOM	Exxon Mobil Corporation	$86.00	2010-12-31	9.1%	16.9%	0.94	14
DIS	The Walt Disney Company	$42.21	2010-12-31	7.8%	23.8%	1.10	15
JNJ	Johnson & Johnson	$64.17	2010-12-31	6.9%	37.7%	2.05	16
HD	Home Depot, Inc.	$37.37	2011-01-31	8.2%	19.9%	1.33	17
BA	The Boeing Company	$75.03	2010-12-31	7.4%	22.3%	1.15	18
KFT	Kraft Foods Inc.	$33.21	2010-12-31	6.7%	33.2%	1.04	19
VZ	Verizon Communications	$36.89	2010-12-31	8.8%	14.0%	0.73	20
KO	The Coca-Cola Company	$67.50	2010-12-31	4.8%	25.0%	1.17	21
T	AT&T Inc.	$30.60	2010-12-31	7.4%	15.6%	0.59	22
DD	E. I. du Pont de Nemours and Company (DuPont)	$54.93	2010-12-31	6.1%	17.3%	2.03	23
CAT	Caterpillar Inc.	$108.11	2010-12-31	6.4%	14.1%	1.45	24
AA	Alcoa, Inc.	$16.72	2010-12-31	5.1%	4.5%	1.31	25
MRK	Merck & Co Inc.	$34.12	2010-12-31	3.0%	11.8%	1.86	26

The Dow tech stocks dominate the top of the rankings. These are and have been very profitable firms, and the recent sell-off in tech has made them attractive on a valuation basis. Several of these are screened into the "official" Magic Formula lists at current.

Also, close lookers may have noticed that 4 of the Dow stocks are missing: American Express (AXP), Bank of America (BAC), JP Morgan (JPM), and Travelers (TRV). The method of ranking unfortunately does not work for financial stocks such as banks and insurance companies.

Conclusion

Ranking groups of stocks by the Magic Formula method is an interesting way to filter down to the most attractive opportunities out of a basket of choices. It's not perfect. For one, dividend yield is not considered, and we are comparing statistics against past earnings with little regard for future prospects. But it is a simple, meaningful way to find stocks for further consideration.

Disclosure: Steve owns MSFT

MagicDiligence put out a post last week examining some of Magic Formula Investing inventor Joel Greenblatt's interviews leading up to the release of his newest book, The Big Secret for the Small Investor. I was able to read the book over the weekend and wanted to post some of my thoughts concerning it.

First of all, like The Little Book that Beats the Market, this is a short, easy read that can easily be completed in a single sitting. The target audience is the individual investor, although I believe it is helpful to have a little knowledge of business accounting before reading this one. While The Little Book can be easily digested and understood by even the most novice investor, Big Secret assumes also that the reader has at least a basic understanding of valuation and return on capital principles.

While I originally assumed that the book was designed as a promotional piece for Formula Investing's "value weighted indexing" funds, that's not really an accurate description (in fact, those funds are never mentioned specifically in the book). Greenblatt starts off by going through a simplified example of how to value a business using discounted free cash flow (DFCF). He makes the point that, in order to follow Ben Graham's advice to buy with a margin of safety, you first have to have a value for the business in the first place! Greenblatt then shows how small assumptions in a DFCF can make huge differences in the calculated value of a company. The point: it's hard and often inaccurate to try and value a business in this manner.

Next, he briefly looks at some alternative valuation methods - comparing a firm's valuation against historical norms and competitors, doing a sum-of-parts valuation, and looking at liquidation value. While Greenblatt agrees that these can be valuable processes, he argues (correctly) that most individual investors don't have the expertise, time, or want to work these out.

These guidelines established, the book then delves into solutions to the problem for individual investors. The first he advocates is something I call the "Buffett solution": stick only to companies that have stable cash flows and predictable growth, thus making it much easier to properly guess guidelines for the different valuation techniques.

Aside from this, Greenblatt says that most investors simply want their money managed for them and don't want to deal with it. This leads into a discussion of the mutual fund industry. I thought Greenblatt did a good job of explaining why it is so difficult for mutual funds to consistently outperform the market, given their focus on attracting and keeping assets and the requirement to outperform every quarter lest clients take their cash somewhere else.

From there, he focuses on index funds. It is shown that market cap weighted index funds, like those tracking the S&P 500 or Russell 1000, consistently beat the vast majority of actively managed funds. But can an index fund do even better? Sure. He then goes on to show that an equal weighted fund (where all stocks in a fund are owned equally, instead of weighted by market cap) does even better - in a range of 1-2% annually over the long term. Fundamentally weighted indexes, where more money is put into firms that are larger on the basis of earnings, revenues, or book value, are presented as another option that outperforms the traditional market cap weighted funds.

This leads up to the money shot - Greenblatt's idea of "value weighted index" funds. This is where you take the top X number of stocks from a group (say, the largest 1,400 stocks by market cap on U.S. exchanges), rank them using value metrics (say, a combination of earnings yield and return on capital), and buy more of the ones that rank the highest. This, of course, is exactly what his new funds created through Formula Investing do.

The big question is: how did this strategy back-test? Pretty well, I must say. According to the book, from 1990-2010, the value weighted index strategy would have returned 13.9% compounded annually vs. 7.6% for the S&P 500, and 7.9% for the Russell 1000.

Overall Impressions

If I had to pigeon-hole Greenblatt's books, I would say that The Little Book is great for beginning investors who want to be active managing their money, The Big Secret is great for the "lazy" investor who wants something better than an index fund, and You Can Be a Stock Market Genius as ideal for the advanced investor looking for an edge to find individual stocks.

My favorite chapters of The Big Secret are the ones where Greenblatt goes into the areas where individual investors have clear advantages over "big money". These chapters are kind of a Stock Market Genius "lite", and if you like them too, go read that book!

In all, this was probably my least favorite of Greenblatt's 3 books, but inactive investors may disagree. It is certainly well worth the $10 price on Amazon and 2 hours of your time, regardless of your experience level in investing.