The Debt Ceiling Deal's Effect on Magic Formula Stocks

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Congress finally got serious on Tuesday and passed the raising of the debt ceiling, allowing the government to continue its addiction to debt and preventing a default on that entity's numerous bills. Any publicly traded business run the way the federal government is run would quickly find itself on the pink sheets (or in bankruptcy court), but I digress.

In a nutshell, the deal allows the federal government to raise the debt ceiling by $2.4 trillion dollars. To balance this act, an initial $917 billion in spending cuts over the next 10 years is in the bill. Additionally, a congressional committee will be appointed to find another $1.5 trillion in spending to cut, by Thanksgiving of this year. If the committee does not come to an agreement, a pre-arranged set of spending cuts will kick in (the "trigger cuts").

In this article, I want to focus on the current Magic Formula stocks that will face disproportionate hits from spending pullbacks. Let's take a look at 3 well-represented Magic Formula Investing (MFI) sectors that are at risk.

Defense Contractors

Over the years, defense contractors have enjoyed generally increasing budget dollars, combined with excellent competitive advantages stemming from long-term relationships with the Department of Defense, allowing good returns on capital. At the same time, due to a limited addressable market, investors have never bid the stocks up much, leading to relatively low valuations. This is a perfect scenario for showing up in the Magic Formula screens, and in fact, even in good times, this sector is a staple of the strategy.

Unfortunately, this is also probably the most obvious group hit by the debt ceiling deal. Of the initial $917 billion in cuts, about a third come out of defense. Additionally, if the "trigger cuts" are reached, many analysts estimate another $600 billion, or more, will get taken out of defense. For firms that rely on federal defense dollars, this is a harrowing prospect.

The Magic Formula stocks most affected are the ones that rely almost solely on the feds for revenue. Lockheed Martin (LMT), Northrup Grumman (NOC), Raytheon (RTN), SAIC (SAI), and ManTech (MANT), all get 85% or more of revenue from the U.S. government. Other defense-oriented firms with a bit better private sector exposure include Harris (HRS), at ~65% exposure, and OshKosh (OSK), at 72% exposure.

It is difficult to say exactly where the cuts will come, but it is likely that all of these firms will see reductions to at least some of their programs.

Home Health Agencies

Given the growth demographics for America's elderly, home healthcare providers have offered investors the promise of a secular growth industry, combined with low capital requirements producing good returns on equity. The entire sector has been listed in MFI at one point or another over the past several years.

The two current ones are Almost Family (AFAM) and industry leader Amedisys (AMED). Both of these companies rely on Medicare reimbursements for over 80% of revenue, with state-run Medicaid a significant portion of the balance. This leaves them hugely dependent on Medicare reimbursement rates for their finanical well-being.

We've already seen cuts from the "ObamaCare" plan passed last year. Reimbursements to home health fell by over 5% this year, with another similar cut for 2012. Medicare is rumored to face cuts if the "trigger" plan kicks in.

The ultimate effect here is less certain than in defense. Medicare cuts are a politically sensitive issue, and the program is already squeezing this sector. Home health care is a cost effective alternative to hospital and nursing home care, so it might be able to avoid additional scrutiny.

For-Profit Education

Can this sector catch a break? For the past 18 months, stocks of for-profit educators have been beaten down as the Department of Education rolled out new regulations and prominent short-sellers turned the market against them. Now, with the new regulations in the books, they are hit with the prospect of government funding reductions in grants and loans.

For-profit education is well represented in MFI, with 6 current stocks: Apollo Group (APOL), Career Education (CECO), Capella (CPLA), ITT (ESI), Strayer (STRA), and DeVry (DV). All of these firms except for ITT generate over 75% of revenue from government-backed Title IV loans. Historically, for-profit school loans have defaulted at about twice the rate of public schools, so this is potentially an area the government may open back up for scrutiny.

These stocks have not traded down in fear as the previous two sectors have. With DoE regulations just passed, with the goal of addressing the default problem, it is probably prudent for the government to let them play out before taking new actions. Also, education spending is another politically sensitive topic that lawmakers may not want to deal with, particularly with an election year coming up.

Buy When Others are Fearful?

Certainly, the mandated cost cutting from the federal government will have adverse affects on most of these companies. However, we have to remember that the market has probably already priced this in - and then some.

Valuations in the defense sector are extremely low. Northrup is at its lowest valuation in over a decade, while Lockheed and Raytheon are at the bottom of their historical ranges. What's more, many of these firms pay large, well-supported dividends. Lockheed pays 4%, Raytheon 3.8%, and Northrup 3.3%. I would avoid non-payers such as SAIC and OshKosh, at this point.

Valuations in home health are even lower. Both AFAM and AMED trade at a P/E ratio barely above 7. These are bankruptcy valuations, but the truth is that both of these firms have both organic volume growth, and have the opportunity to consolidate a large and fragmented market. The sell-off looks overdone.

Disclosure: Steve owns NOC, AFAM, APOL

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