And great returns aren’t the only thing USMO has going for it. As a matter of fact, it has almost everything we look for in the Micro-Cap Magic Formula Newsletter. Hated industry, strong cash flows, rock bottom valuation, focus on returning cash to shareholders… sounds like a screaming buy, right?
USMO’s place on the current magic formula screen shows the danger of blindly following the screen (or any quantitative screen, for that matter). USMO is in the pager business!!! Their core business is declining at a rate of ~20% per year and will continue to decline in the future. In all likelihood, the decline will be at slightly slower pace than in the past few years, but it will continue to decline at a rapid pace. This means their past earnings are in no way indicative of what they will earn in the future.
Now this isn’t to say their stock isn’t undervalued. It could be. We’ve seen gurus like Seth Klarman make great returns with dying companies that focus exclusively on maintaining what’s left of their business and returning all cash to shareholders. Until recently, you could have argued that’s what USMO was.
But in March the company acquired Amcom, a software company, for over $160 million, or over 3x revenues. USMO noted that AMCOM is in a tremendous growth industry and has a lot of synergies with USMO’s current customer base. That could be true. The company certainly makes a compelling argument for it and if it works out like the company envisions, the stock would likely be much higher than today’s prices.
But you could do much better in building a magic formula basket. Two stocks we’ve discussed before, Aeropostale (ARO) and Almost Family (AFAM), have returns on capital and valuations similar to USMO but are in businesses that aren’t facing imminent death and aren’t undergoing a massive strategy shift. I’d much rather invest in a basket of those stocks than a basket of stocks like USMO.
Even better, you could check out our own Micro-Cap Magic Formula Newsletter. We look for stocks with returns on capital and valuations similar to USMO but in industries likely to grow and thrive over time. We also take advantage of the quantitative limitations of the screener by looking for stocks too small to be picked up by the magic formula screen. It’s early, but our first pick is up almost 20%, and our second pick trades for half the multiples of its peers and is being pushed by activists to unlock shareholder value.