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Joel Greenblatt's “Magic Formula” has proven to be one of the most popular (and successful) mechanical value investment screens. By finding stocks with above average earnings yields and returns on invested capital, the magic formula consistently outperforms the market. However, the magic formula has one blind spot: “micro-cap” stocks, specifically those under $50 million in market cap. The Micro-Cap Magic Formula Newsletter will capitalize on that blind spot by digging through stocks too small to make the official magic formula screen.
This newsletter will capitalize on that blind spot by digging through stocks too small to make the official magic formula screen. Each month, the Micro-Cap Magic Formula Newsletter will pick a new stock from this neglected area. By picking one stock per month, the newsletter will build a diversified magic formula portfolio.
So what, specifically, are we looking for in our stocks?
We're looking for the cheapest, highest quality micro cap stocks. We want to approach our magic formula stocks like any good value investor would. The stock we pick each month needs to be more than just cheap. It needs:
1. A history of solid profitability
June:This month's stock consistently generates fantastic returns on capital. Revenue was up over 80% year over year in their most recent quarter, and profits were up over 400%.
Even better, the CEO is a value investor who owns a meaningful amount of stock, and the company is an absolute share cannibal when it comes to buying back their own shares.
May: This month's magic formula pick returns to an industry we've dipped our toe into twice before. Both of the previous picks have been home runs with one up over 30% in under six months and the other up almost 200% in less than a year. This month's pick would be attractive as a stand alone investment. It's dividend yield is 6.5%, its trading for a fair valuation, and the company seems poised to grow rapidly as they complete a corporate transition almost a decade in the making.
April: This month's magic formula stock is also a special situation. The company's already been put in play by an activist shareholder looking to purchase the company on the cheap.
February: This month's pick is barely trading above the value of it's cash. Normally, these cash type bargains are reserved for companies posting massive losses and burning through their assets.
December: This month's newsletter pick is growing at over 10% per year, year after year. Even better, the company has gross margins over 75%, so that growth can throw of tons of cash flow. We will buy the shares on Monday.
November:This month's pick has been growing sales at almost 10% per year for the past few years, more than three times the growth rate of its larger peers. Despite this faster growth, and the fact it is one of the most profitable companies in its industry, the company trades for about half the multiple it's bigger peers do.
October: This month's pick sports a mouthwatering ROIC of over 75%. Even better than its strong ROIC is its consistent ROIC- its ROIC has been above 30% for the last 10 years, and it hasn't produced an operating profit over that entire time frame. As an added bonus, the company sports a nice dividend yield of just under 4% and has shown a willingness to both raise the dividend and buy back shares.
September: This month's pick is our second pick in this industry. Our first pick in the industry is up >50% in less than three months.
August:This month's pick is trading at under 6x trailing earnings and currently sports a dividend yield of almost 6%.
JulyThis month's stock is growing at over 25% per year. Another year of 25% growth will have the company trading at under 3x EBIT in the near future.
June: This month's Magic Formula Pick: strong cash flows, huge ROIC, tremendous upside potential, and several clear catalysts for value realization.
May: This month's pick has been growing at rates normally reserved for tech startups like Facebook and Twitter: revenues have almost tripled over the past five years. Despite that, the company is trading for a decidedly un-Facebook like multiple of under 6.5x EV / EBIT and less than 10x earnings.
April: This month's pick is a dominant player in a small but extremely profitable industry. You could almost equate it to the paypal of its industry, where it matches 100s of buyers and sellers and takes a small piece of each transaction. March: This month's magic formula stock has more than tripled their revenues over the past five years, and they're forecasting revenue growth over 30% this year. Despite that, the company trades for under 10x trailing earnings, and their earnings are actually significantly depressed by an investment management is making that they're forecasting 25% IRR for.
Feb. This month's magic stock is buying back 16% of their shares within the next three months. Its fair value is at least 90% above today's prices.
Jan. This month's pick trades for a huge discount to all of its peers. And one of its divisions has increased revenues almost 10x in just 8 years. It dominates its small niche and is just hitting an inflection point where there growth may actually accelerate. Half of its market cap sits in cash.
Dec. This month's pick has a cash balance almost equal to its share price. It has two activists pushing it to repurchase their significantly undervalued shares. And the core business trades for just 6x EV / EBIT.
November: This month's stock is heavily dependent on the commercial construction industry. Obviously, it's been dramatically affected by the ongoing economic crisis. This month's pick is trading for just 120% of its net cash value and a ~5% dividend yield.
Oct. 2011: This month's pick enjoys returns on tangible capital better than all but a handful of companies in the United States. Their returns aren't inflated by one great year or a strong cycle; rather, the company has consistently earned out of this world returns on capital every year for the past ten years. This is a recession resistant (almost recession proof!) business that is growing with secular tail winds. Management and insiders own over 50% of the company, and that ratio is growing because the company buys back so many shares.As a matter of fact, it's not a stretch to imagine them buying back all of their publicly traded float within the next 4-5 years. All this in a company that trades for just 7-8x free cash flow makes this stock an excellent addition to our micro-cap magic formula portfolio.
September:This month's pick is generating returns on assets over 40% despite a balance sheet loaded with excess cash. They're a market leader with a great reputation and significant competitive advantages, and management is committed to returning cash to shareholders through a nice dividend program.
The company trades for a discount to its competitors despite employing a better balance sheet and enjoying better returns on capital. The industry is also very acquisitive, and a competitor could make an acquisition at a significant premium to today's prices and still find the acquisition very accretive.
August: This month's pick has been hammered by the weakened consumer and stalled out economy. Despite that, the company is generating great cash flows and returns on capital better than 60% of the S&P 500. It's got a distribution network that's almost impossible for newcomers to replicate, and they're buying back shares and pay a nice dividend. The company is still run by its founders, who have a proven history of growing shareholder value, and insiders own almost 41%.
So what are you paying for a company with all of these great treats? Not much. They trade for under 4.5x EV / EBITDA, about half the multiple most competitors trade at. We think shares are worth at least 50% more than their current price, and that target will prove much too conservative if their new product proves as successful as management thinks it can be.
July: This month's pick is trading for just over 6x EV / EBIT. All of its peers trade for at least 9x despite possessing weaker balance sheets and lessor returns on equity and capital. And the space is ripe for consolidation- just this week, one of their main competitors got bought out in a huge private equity deal. And given the recession resistant nature of the business, don't be surprised if private equity or a strategic acquirer comes looking at them sometime in the near future.
June: This month's pick has grown earnings by over 100% year over year. Even better, the company's earnings actually understate their true cash flow because an accounting rule requires them to take a non-expense. Despite this, the company trades for under 5x EV / EBIT. Insiders own over 60% of the company, and they must think the stock is cheap too... In November, they hired a strategic adviser to help them unlock shareholder value. With 20% of their current market cap sitting in excess cash, it shouldn't be too hard for them to figure out a way to do that.