One of the great things about the Magic Formula (MFI) strategy is that it can dig up attractive investment opportunities for any size companies.
Prefer to play it safe and invest only in blue chip stocks with billions in revenue? No problem - MFI can quickly find you great large capitalization stocks.
On the other hand, do entirely unknown, small companies with a blue ocean of growth potential and the opportunity to double, triple - or even more - their stock price get your investing juices flowing? That's great! The strategy's best results are from including stocks as small as $50 million in market cap.
In fact, during Joel Greenblatt (Trades, Portfolio)'s study, detailed in The Little Book that Beats the Market, including the market's smallest cap stocks improved the strategy's performance three-fold!
Today, I want to highlight one of these micro-cap MFI stocks that appears to have significant upside potential of 55%... or more.
Natural Health Trends - A Mini Nu Skin
Natural Health Trends (NHTC, Financial) is a first stage version of long-time MFI stocks Nu Skin (NUS), Herbalife (HLF), and USANA Health Sciences (USNA).
Right off the bat this is pretty intriguing. Those three companies netted our Top Buys portfolio gains of 57%, 60%, and 74% (respectively) during prior recommendation periods!
Natural Health Trends is just like those firms: a direct selling, or multi-level marketing (MLM) firm that sells wellness, skincare, and "lifestyle" products. The wellness segment markets beverages, supplements, and protein powders, with brands such as Noni Juice, Trotein, FibeRich, etc. Skincare items include cleansers, moisterizers, wrinkle creams, and masks. Brands here include Skindulgence, Time Restore, and Soothe. Finally, the global lifestyle division sells Alura and Valura, sex aids for men and women respectively, and La Vie, an herbal energy booster.
Natural Health does most of its business in Hong Kong, with 73% of its distributor base there and about 77% of revenue. Its second largest base is in Russia (about 11% of total distributors), and North America accounts for just over 6%.
Like Nu Skin, Natural Health does not run an MLM in China due to regulations, instead using a traditional e-commerce model there.
Booming Growth...
By far the most attractive thing about Natural Health is its growth trajectory. Since 2010, the company has expanded revenues at a torrid 29% compound annual growth rate (CAGR), while expanding margins from 5.3% in 2011 to 10.5% today, leading to a profit CAGR of 62%!
The most recent quarter was nothing short of eye-popping. NHTC's revenues expanded almost 3-fold (168%) while operating margins ballooned to 13.5%. To put it in perspective, NHTC's $3.1 million in pre-tax income last quarter was more than it has made in any year in its history save for 2013.
And if that wasn't enough, yesterday the company filed a press release pegging preliminary Q2 revenues at $34.2 million, which represents a cool 223% year-over-year (and 48% sequential) growth figure! The stock was up another 13% yesterday on this news.
There is nothing particularly fluky about this growth either. Like Nu Skin in China, or USANA in Hong Kong, it is just a function of the company's organization reaching critical mass. In Natural Health's case, this is Hong Kong, where essentially all of its growth is coming from.
You have to like the company's trajectory and prospects going forward. This is still a very small firm. It's $67 million in revenues is just 1.3% of Herbalife's $5 billion, 2% of Nu Skin's $3.3 billion, and 9% of USANA's $731 million.
... At A Very Reasonable Price
Although the stock's chart looks like Mt. Everest over the past year, the valuation is still quite reasonable here. At just a 13.6 P/E, NHTC is valued below-market. MLM firms in general have exhibited wide swings in valuation over the past 5 years, and are currently in a trough. Even if NHTC had only modest growth, a rebound in P/E to a more market-average 16 would be worth 23% in the stock. Obviously, I think the upside is far greater than that, given the growth outlook.
Not Without Risks
No opportunity comes without risks, and NHTC has its share. Lets look at them now.
First, this is an over-the-counter (OTC) stock, not traded on the major exchanges. That makes its liquidity a potential issue - less than $230k is traded in the stock daily. If you want to buy or sell, it is critical to use limit orders!
Secondly, the company is very reliant on its Hong Kong operations. Any whiff of investigations or potential regulatory changes could dramatically affect the stock.
Third, this is an MLM that will be affected by the news (usually negative news) driven towards its larger brethren. MLM stocks are popular targets for hedge fund short attacks, misleading media campaigns, grandstanding politicians, and so forth.
Finally, the stock is not one for the weak of stomach. 20% swings in the span of a couple weeks has not been, and won't be, unusual. This is a volatile, micro-cap stock.
Conclusion
For the risk-aware, Natural Health Trends represents an attractive, micro-cap Magic Formula stock trading at a reasonable valuation with very high upside potential. I believe the stock could go up to $12.50 in the short term, and even higher than that with time.
