Miracle Formula Investing: Performing An Investment Miracle With CVS Health Corp. And Rite Aid Corp.

| About: CVS Health (CVS)

Summary

Miracle Formula Investing is based on the Magic Formula Investing principles taught by Joel Greenblatt.

Long CVS: ROC is 65.19% and Earnings Yield is 8.37%.

Short RAD: ROC is 14.13% and Earnings Yield is 3.42%.

Estimated return is 6.13% or 4.29% yield over and above 5-year U.S. Treasuries.

How can you perform an investment miracle?

It is said that God created the world in 6 days and then rested. In the act of creation, God created something out of nothing (or ex nihilo as they say in Latin). My thesis is: if you are correct in your market neutral trade then you created an investment miracle by taking little to no capital and created profitable returns. In this article, I'll teach you a new form of investing I call Miracle Formula Investing - a simple way of market neutral investing.

To learn more about market neutral trading, please check out the following links.

In this article, I discuss a potential money making trade that consists of longing CVS Health Corp. (NYSE:CVS) at the same time shorting Rite Aid Corp. (NYSE:RAD). I will cover 3 signs why this is a high probability trade. Before we get into 3 points, let me tell you more about the background of these two companies.

Companies

CVS Health Corporation, together with its subsidiaries [CVS Health], is a pharmacy company. The company operates through three business segments: Pharmacy Services, Retail/LTC and Corporate. CVS offers a range of products and services, such as advising patients on their medications at its CVS Pharmacy locations, introducing programs to help control costs for its clients at CVS Caremark, how care is delivered to its patients with conditions through CVS Specialty, pharmacy care for the senior community through Omnicare. The Pharmacy Services Segment provides a range of pharmacy benefit management [PBM] solutions. The Retail Pharmacy segment includes retail drugstores, online retail pharmacy Websites and its retail healthcare clinics.

Rite Aid Corporation is a retail drugstore chain. The company's segments include Retail Pharmacy and Pharmacy Services. RAD operates under The Rite Aid name. It operates approximately 4,560 stores in over 30 states across the country and in the District of Columbia. The company's Retail Pharmacy segment consists of Rite Aid stores, RediClinic and Health Dialog. It sells brand and generic prescription drugs, as well as an assortment of front-end products, including health and beauty aids, personal care products, seasonal merchandise, and a private brand product line. Its front-end products include over-the-counter medications, health and beauty aids, personal care items, cosmetics, household items, food and beverages, greeting cards, seasonal merchandise and numerous other everyday and convenience products. The company's Pharmacy Services segment consists of EnvisionRx, which provides a range of pharmacy benefit services.

Sign 1: Miracle Formula Investing is based on the highly profitable Magic Formula Investing

If you don't believe in miracles, then maybe you believe in magic. You may have heard of Joel Greenblatt's Magic Formula. This investment guru (Greenblatt) taught us a simple, but effective way to invest based on two factors: 1) quality and 2) value. He measured quality based on return on capital. Greenblatt used earnings yield to measure how undervalued or overvalued the stock is.

For more discussion on the Magic Formula, please see the following article I wrote on it.

You may be asking can the Magic Formula really make me some money? Show me the money you're saying. If a picture is worth a thousand words, then may be a table can answer several questions. The following table is an excerpt from page 158 of the book, "The Little Book that Still Beats the Market" by renown Joel Greenblatt:

Table A.2

Annualized Return (1988-2009)

Group 1

15.2%

Group 2

12.7

Group 3

12.1

Group 4

11.5

Group 5

10.7

Group 6

10.2

Group 7

8.8

Group 8

7.1

Group 9

4.1

Group 10

0.2)

This table is a summary of roughly 2,500 of the largest companies in the United States ranked by the Magic Formula each month and divided into deciles (10 percent groups) based on their rankings and held for 1-year. Group 1 beats Group 2, which beats Group 3 and so on so forth.

My thesis is that you can create alpha (or excess return above the market return) by performing a market neutral trade longing Group 1 ranked stocks at the same time shorting Group 10 stocks in the same industry/sector. By longing the undervalued quality stock using the classic Magic Formula (the Group 1 stocks), you can find stocks that are heading to the heavens. By shorting the Anti-Magic Formula (the Group 10 stocks), you will likely find companies that will trade down to earth. Combining the long and short, you have the Miracle Formula for market neutral investing. This is heaven on earth.

Let's continue with an example of how Miracle Formula Investing works with CVS and RAD.

Comparing the two Magic Formula Investing factors we find that CVS is more undervalued and has a better quality than RAD.

CVS

RAD

ROC: EBIT / (Net Working Capital + Net Fixed Assets)

65.19%

14.13%

Earnings yield: EBIT / Enterprise Value

8.37%

3.42%

Because CVS ranks higher for both quality and value than RAD, CVS is a better buy than RAD.

Sign 2: 2nd opinion based on Value Line's estimates

Like an important medical decision, you always want a second opinion. I recommend using Morningstar and Value Line to double check your investment decisions.

According to Morningstar, CVS has a Fair Value Estimate of $104.00 implying a 20.41% margin of safety. Unfortunately, Morningstar does not give a valuation of RAD at this time. However, a quick check of Value Line shows it does have a Target Price Range for both stocks.

CVS

RAD

Value Line Target Price Range Low

120.00

8.00

Value Line Target Price Range High

145.00

14.00

Value Line Target Price Range Average

132.50

11.00

Current Price

82.77

8.60

Margin of Safety

37.53%

21.82%

Based on Value Line's average Target Price Range for the next 3-5 years, it implies that the compound average growth rates [CAGR] for CVS and RAD are 12.48% and 6.35%, respectively. This means you are projected to make a spread of 6.13% (12.48% - 6.35%) if you long CVS and short RAD. Given the 5-year U.S. Treasury Yield is about 1.84%, you can make a 4.29% yield over and above treasuries. This is huge. The measuring stick for market neutral trading is how much return can you make above risk free rates.

Sign 3: Insider activity

The last sign is insider activity. Thesis: buying opportunities can be found by looking at when insiders are buying. Checkout this article entitled, "When insiders buy, should investors join them?", for why this can be a tell against other investment poker faces.

A check at Morningstar's website, we find that insiders have been buying at CVS, but there has been little buying by insiders at RAD.

Conclusion

Expecting a miracle? CVS and RAD may be your answer. We covered the three signs why I believe a market neutral trade longing CVS and shorting RAD is a potential money maker. Perform your own miracle investments by using my Miracle Formula. If you don't believe in miracles, then you may be impressed with a little magic.

Update 1/12/2017 1:22 p.m.:

Addendum:

Thanks to the wonderful Seeking Alpha readers' comments, I needed to make a correction to my article. I added a step to the Miracle Formula. It is: check the news for possible M&A deals and do your own homework.

Luckily, I did a valuation analysis of RAD beforehand. I did forget to look for M&A news-my bad!

Sign 4: Beware of mergers and acquisitions

Just because there is an offer to merge or acquire the stock does not guarantee it will go through. In this case, I a betting it won't for Rite Aid. Or if it does, not at the $9 per share price. Why?

My valuation of the stock and the margin of safety. The following is a table of my various valuation metrics:

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments

CVS

RAD

Industry Enterprise Multiple (EBIT)

15.99

15.99

Industry Enterprise Multiple (EBITDA)

8.06

8.06

EBIT

11,184.00

645.00

EBITDA

13,613.00

1,198.00

Preferred Equity

-

-

Debt

26,733.00

7,174.00

Minority Interest

5.00

-

Cash & Investments

2,263.00

136.00

Shares Outstanding

1,084.00

1,042.00

Implied Valuation (EBIT)

142.40

3.14

Implied Valuation (EBITDA)

78.64

2.51

CVS

RAD

Price-to-Earnings (TTM)

17.60

64.60

Price-to-Earnings (Forward)

14.15

43.00

Price-to-Earnings (Industry Average)

21.05

21.05

EPS

4.68

0.13

EPS Estimate

5.85

0.20

Implied Valuation

98.51

2.74

Implied Valuation (Forward)

123.14

4.21

Implied Valuation (Average TTM & Forward)

110.83

3.47

PEG

1.00

N/A

CVS

RAD

Sales Growth Year over Year

9.99

15.86

Sales Growth 3-Year Average

7.58

6.57

Sales Growth 5-Year Average

9.72

4.04

Price-to-Sales

0.50

0.30

Price-to-Sales (Industry Average)

0.65

0.65

Sales per Share

159.32

31.32

Net Margin (Industry)

0.020

0.020

Net Margin

0.030

0.004

Premium/Discount

1.48

0.21

Implied Valuation

153.15

4.21

CVS

RAD

Price-to-Book

2.40

14.30

Price-to-Book (Industry Average)

3.00

3.00

Book Value per Share

33.71

0.58

Implied Valuation

101.13

1.74

CVS

RAD

Combined P/E (TTM & Forward), P/S & P/B Valuations

119.73

2.94

CVS

RAD

EPS

4.68

0.13

Growth rate next 10 years

11.50%

5.00%

Terminal growth rate

4.00%

4.00%

Years of terminal growth

10.00

10.00

Discount rate

7.95%

12.00%

Tangible book value

(14.85)

(1.86)

Growth value

56.04

0.93

Terminal value

52.88

0.46

Implied Valuation (DCF)

108.92

1.39

Revenue Growth Rate 1 year

20.70%

9.30%

Revenue Growth Rate 5 year

14.20%

-0.80%

Revenue Growth Rate 10 year

11.50%

-1.10%

Reverse DCF Growth Rate

7.39%

32.55%

CVS

RAD

Combined P/E (TTM & Forward), P/S & P/B Valuations

119.73

2.94

Implied Valuation (EBIT)

142.40

3.14

Implied Valuation (EBITDA)

78.64

2.51

Implied Valuation (DCF)

108.92

1.39

Average Fair Value Estimates

112.42

2.50

Current Price

82.77

8.60

Margin of Safety

26.38%

-244.44%

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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