To keep myself sharp and my skills honed, I routinely go to my library of investment books and re-read classics that have had an impact on me. This week I did a complete re-read of Joel Greenblatt’s classic “The Little Book That Beats The Market.” For any of you that are not familiar with the book, Joel Greenblatt presents his magic formula for picking stocks that his research indicated will beat the market most of the time.
In Chapter 10 Joel Greenblatt presented the results of magic formula stocks. Although he did admit that the formula underperformed the market in one out of every four years tested, and the magic formula underperformed the market in one out of every six year periods tested, he provided what he called the good news as follows:
“Following the formula for any 3 year period in a row, the magic formula beat the market averages 95% of the time (160/169 three-year periods tested! But that is not all! Over three-year periods, if you follow the magic formula, you would have never lost money.”
Considering all that has happened in 2020, I thought it might be interesting to present a screen of stocks based on Joel Greenblatt’s magic formula. Furthermore, I thought it would be refreshing to look for under-followed small and mid-cap companies that could be looked at as potential research candidates capable of generating above-average and attractive total returns.
5 MidCap 2020 Magic Formula Stocks
The magic formula ranks companies based on two factors: return on capital and earnings yield. However, instead of the normal earnings yield calculation which is the inverse of the P/E ratio, Joel Greenblatt utilized a different method for calculating earnings yield. With his method, he utilized pretax operating earnings (EBIT) to enterprise value.
Joel Greenblatt preferred utilizing enterprise value over market value because it takes into account both the price paid to take an equity stake in the business as well as the debt financing used by the company to generate operating earnings. In a preferred EBIT (earnings before interest and taxes) because it considered full purchase price of the business (both equity and debt).
Utilizing the magic formula, I ran a screen for MidCap companies that produced a list of 30. Then, I went through each of those 30 companies and picked 5 that I felt offered the best potential and shown the strongest fundamentals. You will see later, that because these are small companies, they do not all have great operating histories. However, I did feel that these 5 had the best fundamentals out of the 30 companies, and in addition to being magic formula selections, I also like the valuations and future potentials. Therefore, I offer the following 5 magic formula stocks to those investors that are interested in beating the market based on an above-average total future return.
5 MidCap Magic Formula Stocks: Basic Fundamentals and Valuations
The following table provides a summary of the 5 research candidates magic formula selections. As you can see, each of these 5 offer earnings yields and cash flow yields that are significantly above average. Furthermore, even though these are total return selections, 3 of the 5 do pay a dividend.
For each of these 5 selections I offer the following price correlated to EBIT (earnings before interest and taxes) FAST Graphs and return on invested capital FUN Graph on each of the 5 selections. Clearly, each of these research candidates are attractively valued based on historical price to EBIT valuations (the price is either on or below the orange line on each graph) and therefore offer above-average earnings yields on that basis. And they all generate strong returns on invested capital, with a few of them offering spectacular returns on invested capital.
Allison Transmission Holdings (ALSN)
Company Profile courtesy Seeking Alpha
“Allison Transmission Holdings, Inc., together with its subsidiaries, designs, manufactures, and sells commercial and defense fully-automatic transmissions for medium- and heavy-duty commercial vehicles, and medium- and heavy-tactical U.S. defense vehicles worldwide.
It offers 12 transmission product lines for various applications, including distribution, refuse, construction, fire, and emergency on-highway trucks; school and transit buses; motor homes; energy, mining, and construction off-highway vehicles and equipment; and wheeled and tracked defense vehicles.
The company markets its transmissions under Allison Transmission brand name; and remanufactured transmissions under ReTran brand name. It also sells branded replacement parts, support equipment, aluminum die cast components, and other products necessary to service the installed base of vehicles utilizing its transmissions, as well as defense kits, engineering services, and extended transmission coverage services to various original equipment manufacturers, distributors, and the U.S. government.
The company serves customers through an independent network of approximately 1,500 independent distributor and dealer locations. The company was formerly known as Clutch Holdings, Inc. Allison Transmission Holdings, Inc. was founded in 1915 and is headquartered in Indianapolis, Indiana.”
Catalyst Pharmaceuticals Inc. (CPRX)
Company Profile courtesy Seeking Alpha
“Catalyst Pharmaceuticals, Inc., a biopharmaceutical company, focuses on developing and commercializing therapies for people with rare debilitating, chronic neuromuscular, and neurological diseases in the United States. It offers Firdapse, a proprietary form of amifampridine phosphate for the treatment of patients with lambert-eaton myasthenic syndrome.
The company also develops Firdapse, which is in various clinical trials for the treatment of patients with congenital myasthenic syndrome, anti-MuSK antibody positive myasthenia gravis, and spinal muscular atrophy type 3. Catalyst Pharmaceuticals, Inc. has license agreements with BioMarin Pharmaceutical Inc.; and collaboration and license agreement with Endo Ventures Limited for the development and commercialization of generic Sabril tablets.
The company was formerly known as Catalyst Pharmaceutical Partners, Inc. and changed its name to Catalyst Pharmaceuticals, Inc. in May 2015. Catalyst Pharmaceuticals, Inc. was founded in 2002 and is based in Coral Gables, Florida.”