Among consumer cyclical companies that trade on the New York Stock Exchange and the Nasdaq, three retail companies, Bed Bath & Beyond Inc. (BBBY, Financial), Winmark Corp. (WINA, Financial) and Hibbett Sports Inc. (HIBB, Financial) have high Greenblatt earnings yield and return on capital. This suggests that these companies have high value potential based on Greenblatt’s magic formula.
Greenblatt and His “Magic Formula”
As mentioned in an earlier article on technology companies, the Greenblatt magic formula ranks company stocks based on earnings yield and Greenblatt return on capital. Developed by Joel Greenblatt (Trades, Portfolio), founder of Gotham Asset Management, the magic formula implements Greenblatt’s investing strategy based on “value with a catalyst.” Greenblatt targets the companies that are undervalued based on normalized earnings.
Greenblatt’s definitions for the earnings yield and return on capital, as mentioned in The Little Book that Beats the Market, differ from the respective common definitions. Instead of taking the ratio between trailing 12-month EPS and the stock price, Greenblatt takes the company’s EBIT over the enterprise value to find the company’s earnings yield. According to the magic formula investor, this earnings yield likely provides a more accurate profitability measure than the regular earnings yield. Greenblatt also calculates the return on capital using EBIT: to calculate the ROC, Greenblatt divides the company’s EBIT with the sum of the company’s net fixed assets and net working capital.
High Earnings Yield and ROC Results in Increased Value
Currently, NYSE and Nasdaq consumer cyclical companies have a mean Greenblatt earnings yield of 1.23 and a standard deviation of 28.67. Additionally, these companies have a mean Greenblatt ROC of 25.74 with a standard deviation of 238.84. The standard deviations are high, likely due to some outliers: for example, even though Winmark has a regular ROC of just 193.12% as of June 2016, Greenblatt ROC is currently 3248.71%. This suggests that Winmark likely has strong upside value potential in the short-term.
Companies with above-average earnings yield and ROC are likely good investments. Among all consumer cyclical companies, about 23.51% are likely good investments based on their earnings yield and ROC. Winmark is likely a good investment based on the above criterion. Additionally, Winmark has a high profitability rank despite modest financial strength. Even though the company has relatively low interest coverage and cash to debt ratios, the franchiser of retail merchandise firm has a Piotroski F-score of 8, suggesting a strong business operation.
Even though Bed Bath & Beyond and Hibbett Sports currently have a lower ROC compared to their median ROC, these companies are currently the top two U.S. consumer cyclical stocks listed on the Magic Formula Screener. This is likely because these companies have a lower P/E ratio compared to their 10-year EBITDA growth rate. With a P/E ratio of just 8.89 and a 10-year EBITDA growth rate of 13.9, Bed Bath & Beyond is likely undervalued based on its normalized earnings. Additionally, BBBY’s P/E ratio is also lower than its five-year EBITDA growth rate of 11.5. As mentioned earlier, stocks that trade at cheap prices relative to their normalized earnings make good investments according to Greenblatt.
Hibbett Sports has a P/E ratio just below its 10-year EBITDA growth rate. Although Winmark’s P/E ratio is about 8% lower than its 10-year EBITDA growth rate, the P/E ratio is also about 4% higher than its 5-year EBITDA growth rate.
See Also
Greenblatt usually holds over 80% of his assets in just five to eight stocks. You can view his current portfolio and performance here.
Columnist Punch Card Research recently posted a good article on Winmark, one of the fastest growing retail companies.
Disclosure: The author currently does not have any position in the stocks listed in this article.
