Because we’re optimists, let’s start with the good before we discuss the bad.
The Good: Competitive Advantage
The great thing about the magic formula is it does a really good job of identifying stocks with competitive advantages. Time Warner owns a great set of assets- the Turner Networks, HBO, CNN, Warner Bros, Time (of course), and several more- that clearly give it a huge competitive advantage over potential newcomers.
The magic formula uses ROIC to detect competitive advantages. Why? Simple- because firms with competitive advantages will consistently exhibit extremely high return on tangible invested capital. A firm without a competitive advantage might be able to do it for a year or two, but eventually its high ROIC would attract competitors And when those competitors come in, they’d drive the ROIC for everyone down to a normal, market average.
But with a competitive advantage, competitors can’t enter those markets and drive the ROIC down. And that’s exactly what we see (and what we get) with Time Warner.
And there are plenty of other positives too.
Time Warner’s management has shown a commitment to returning value to shareholders. Everyone remembers the fateful AOL acquisition and the value destruction that caused. But that was under old management.
New management has focused almost exclusively on buying back stock, paying out dividends, and spinning off non-core divisions like AOL and Time Warner Cable. They’ve made a couple of smaller acquisitions, but the vast majority of their cash flow has gone towards returning it to shareholders.
And in terms of valuation, TWX isn’t expensive. It’s not very cheap either, but considering it’s a great business with focused management, paying a market average or slightly below market average multiple isn’t that bad. Currently trading for under 8x EV / EBITDA, under 14x P/E, and with a dividend yield approaching 3%, looks relatively attractive on several metrics.
But that brings us to the downside of the magic formula.
The Bad: Growth and Upside
Does Time Warner have a competitive advantage? Sure. And is it cheap? Relatively, yes.
But Time Warner is a mature company. It has a competitive advantage, but it’s already completely saturated its market. It can’t grow any further within that franchise. Any future growth will be more or less at the rate of the economy. It might even be slower than the economy as some of its stronger magazines succumb to the trend away from print.
In other words, if you were managing billions of dollars, Time Warner would be a pretty attractive place to start investing some money right now. I’d much rather be invested in TWC and a couple of similarly priced businesses with great fundamentals than an index. You’d probably outperform the index by 1% while taking similar or even lower risk. Not bad at all.
So what’s the downside?
The magic formula can help us find firms that might have a competitive advantage and trade for a relatively low valuation. But what we really want are firms with both those characteristics plus a long runway for growth within that franchise. Small investors should probably be trying for more than just a point or two of outperformance. Small investors should be looking for big edges in firms with competitive advantages and long runaways to growth that the big investors can’t invest in. What small investors should really be using the magic formula for is to try to identify something like Walmart in the 1980s, when it still had a long runway to growth and plenty of new stores to open.
That’s where the big money can be made.
That’s how you end up with stocks that are up 4 or 5x your purchase price in 3-5 years.
That’s what we try to do at GuruFocus’s own Micro Cap Magic Formula Newsletter. If you’re looking for some similar ideas, be sure to check the newsletter out. Our next pick comes out this Friday. It’s a firm that’s dominant in their small niche, but the niche has the potential to grow to 5x (or more!) its current size. Almost half of their market cap is in cash, and it wouldn’ t be hard to see them firm getting bought out by a bigger competitor at a significant premium to today’s price.