If you want to increase your chances of beating the market, one method is to select stocks that rank highly in regard to "magic formula" criteria.
About the Magic Formula
Created by Joel Greenblatt (Trades, Portfolio), a prominent value investor and author of "The Little Book That Still Beats the Market," the magic formula ranks stocks based on a specific set of technical criteria. The book also provides a description of these criteria, highlighting the earnings yield and the return on capital as the two most important components of the ranking.
In Greenblatt's book, these two financial indicators are defined a little differently. Greenblatt calculates the earnings yield as earnings before interest and taxes (Ebit) divided by the enterprise value, while the return on capital is Ebit divided by net fixed assets and working capital. In addition to these two ratios, magic formula stocks are characterized by a market capitalization of more than $100 million and for representing only equities in U.S. companies operating in all industries, excluding financial and utility businesses.
In order to not miss some incentives that the fiscal law provides for investors, those magic formula stocks that qualify as losers are sold one week before they have completed one year of continuous holding. The winners leave the portfolio one week after the one-year mark, therefore making space for new stocks.
According to Greenblatt's book, the entire process must be repeated each year for at least five years to have a high probability to outperform the S&P 500. This estimate is based on the results of past back-testing activities, which were made with the intention of gauging the effectiveness of the approach.
Below are three of my stock picks that rank highly on the GuruFocus Magic Formula screener.
HP
The first stock to consider is HP Inc. (HPQ, Financial), a Palo Alto, California-based computer hardware company.
The stock traded at $23.78 per share at close on Dec. 4 for a market capitalization of approximately $32.66 billion, an earnings yield of about 10.7% and a return on capital ratio of 108.38%.
HP's earnings yield ranks better than 83.8% of peer companies, while its return on capital ratio ranks better than 96.88% of companies that operate in the hardware industry.
The share price has risen by 16% over the past year and now stands at 30.4% above the midpoint of the 52-week range of $12.54 to $23.93.
Currently, HP pays quarterly dividends. The next interim payment will be made on Jan. 6 in the amount of 19.4 cents per common share, generating a forward dividend yield of 3.28% and trailing 12-month dividend yield of 2.98% as of Dec. 4.
GuruFocus has assigned a score of 6 out of 10 for the company's financial strength rating and 7 out of 10 for its profitability.
As of December, Wall Street sell-side analysts issued five strong buy ratings, seven buy ratings and six hold ratings for an average target price of $23.33 per share.
Fox
The second stock to consider is Fox Corp. (FOXA, Financial), a New York-based news, sports and entertainment company in the U.S.
The stock closed at $29.84 per share on Dec. 4 for a market capitalization of $17.62 billion, an earnings yield of 12.45% and a return on capital ratio of 69.39%.
Fox's earnings yield ranks higher than 87.63% of peer companies, while the return on capital ratio ranks better than 84.45% of companies operating in the diversified media industry.
The share price has declined by 15.75% over the past year, but it is still slightly above the midpoint of the 52-week range of $19.81 to $39.74.
Currently, Fox pays semi-annual dividends in the amount of 23 cents per common share each, granting a 1.56% yield in terms of a forward and trailing 12-month dividend as of Dec. 4.
GuruFocus has assigned a score of 5 out of 10 for both the financial strength rating and the profitability rating of the company.
As of December, Wall Street sell-side analysts have issued six strong buy ratings, eight buy ratings, 11 hold ratings and only one underperform rating. The average target price is $29.88 per share.
Trinet Group
The third stock to consider is Trinet Group Inc. (TNET, Financial), a Dublin, California-based provider of staffing and employment services to small and midsize companies in North America.
The stock was trading at $77.38 per share at close on Dec. 4 for a market capitalization of $5.16 billion, an earnings yield of 8% and a return on capital ratio of 311.09%.
Trinet's earnings yield ranks better than 71.89% of peer companies, while the return on capital ratio ranks better than 95.45% of companies operating in the business services industry.
The share price has risen by 41.44% over the past year and represents a 43.3% increase from the midpoint of the 52-week range of $27.79 to $80.16.
Currently, Trinet does not pay a dividend.
GuruFocus has assigned a score of 6 out of 10 for both the company's financial strength and profitability ratings.
As of December, Wall Street sell-side analysts issued one strong buy rating, two hold ratings and two underperform ratings for an average target price of $79.25 per share.
Disclosure: I have no positions in any securities mentioned in this article.
Read more here:
- 3 Stocks Trading Below Intrinsic Value
- A Trio of Stock Picks for a 'Buy and Hold' Approach
- A Trio of Capital-Intensive Stocks to Consider
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