Famed investor Joel Greenblatt (Trades, Portfolio) published “The Little Book That Beats the Market” in 2005, which would become a classic in finance literature. The straightforward, easy-to-read book numbers just over 200 pages, and lays out what Greenblatt calls the “magic formula”, a method of picking stocks with low P/E ratios and high returns on capital.
Greenblatt’s formula for return on capital is: EBIT/(Net Working Capital + Net Fixed Assets). The Magic Formula is a relative ranking of companies based on the two criteria, and calls for investors to hold 20-30 stocks for at least one year. After the one-year period, investors should screen for new stocks and establish a new portfolio based on current financial statements and stock prices.
GuruFocus’ Magic Formula screener can be used to sort the companies that fit the formula’s criteria. The following five stocks are the top results when the filters are set to display only S&P 500 companies with a business predictability rating of at least 4 stars.
Aetna currently ranks number one in the Magic Formula Stocks screener, with an ROC of 645.85% and P/E ratio of 19.3. The company provides health insurance products and related services.
Over the past year, the stock has risen 44% and closed at $117.95 on June 11. Aetna’s business predictability is a perfect 5 stars, with revenue growth of 16.4% and EBIT growth of 19% over the past five years.
Net income has remained steady over the long term, increasing marginally by 2.5% over the past five years. In 2014, Aetna posted net income of $2,041 million, up from $1,914 million the year before.
The company’s dividend yield is 0.82%, which is close to the three-year low. The payout ratio is 19%. During the first quarter, Steven Cohen (Trades, Portfolio), Louis Moore Bacon (Trades, Portfolio), and Lee Ainslie (Trades, Portfolio) each initiated a new position in Aetna.
Cisco Systems (CSCO, Financial)
Cisco’s return on capital is 356.35% with a P/E ratio of 16.5. The stock price increased 16% over the past year and closed at $28.54 on June 12.
Cisco designs and manufactures internet protocol (IP) based networking products and services to the communications and IT industry. GuruFocus rates Cisco’s business predictability as 4 out of 5 stars, with revenue growth of 8.2% and EBIT growth of 8.6% over the past five years. The DCF calculator estimates a fair value of $22.02, giving a -30% margin of safety.
Despite a dip in net income in 2014, the figure rose 4.63% over the past five years. The income trend over time is depicted in the graph below.
The dividend yield is 2.73%, while the payout ratio is 45%. Four gurus including Ray Dalio (Trades, Portfolio) and Lee Ainslie (Trades, Portfolio) added Cisco as a new addition to their portfolios during Q1.
UnitedHealth Group (UNH, Financial)
Ranked third on the Magic Formula screener is UnitedHealth Group, with an ROC of 254.88% and a P/E ratio of 1.4.
Over the past year, the stock increased 51% and closed at $117.65 on June 12. With a business predictability of 4.5 out of 5 stars, the DCF calculator estimates a fair value of $96.65, with a margin of safety of -22%.
Over the past five years, UnitedHealth’s revenue grew by 12.5%, while EBIT grew by 13.2%. In 2014, EBIT per share recorded at $10.42, which increased steadily over the years.
Once cause for concern is the company’s current ratio is below 1, indicating UnitedHealth cannot cover its short-term obligations. Five gurus added the stock as new holdings during the first quarter, while NWQ Managers (Trades, Portfolio) was the only guru to sell out of the stock.
Omnicom Group (OMC, Financial)
Omnicom Group is a holding company that provides advertising, marketing and corporate communications services to clients. Its ROC is 277.54% and the P/E ratio is 17.
The stock increased just 3% over the past year, and closed at $72.50 on June 12. Omnicom’s business predictability is rated as a perfect 5 stars. Over the past five years, revenue grew by 9.9%, while EBIT grew by 12%.
In 2014, the company reported net income of $1,104 million, up from $991 million the year before. The trend over time can be seen in the graph below.
Omnicom’s dividend yield is 2.76% — close to the 10-year high — while the payout ratio is 46%. Jim Simons (Trades, Portfolio) was the only guru to add the company as a new position during Q1.
Tech giant Apple is fifth on the Magic Formula screener with an ROC of 348.59%, and a P/E ratio of 15.6. The stock rose 37% in the last year and closed at $127.17 on June 12.
Apple’s business predictability is rated as 4.5 out of 5 stars, with excellent revenue growth of 35.6% and EBIT growth of 37.2% over the past five years.
In 2014, EBIT per share was $8.58, up from $7.51 the year before. Over the past five years, this figure has increased almost 30%.
Apple’s dividend yield is 1.5%, which is close to the two-year low. The payout ratio is 23%. During the first quarter, Caxton Associates (Trades, Portfolio), Ken Heebner (Trades, Portfolio), and Lee Ainslie (Trades, Portfolio) each initiated a new position in Apple.
Use the Magic Formula screener to find stocks with low P/E ratios and high returns on capital. Not a Premium Member of GuruFocus? Try it free for 7 days.
