Joel Greenblatt's Top 'Magic Formula' Stocks

 | Sep 12, 2012 | 3:30 PM EDT
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Joel Greenblatt, the founder of Gotham Asset Management, is widely known for his "magic formula" investment approach. This strategy searches for companies that offer a combination of a high return on invested capital and a high earnings yield. Like many other value investors, Greenblatt seeks stocks whose intrinsic value is substantially higher than the current price level.

Looking at the sector composition of Greenblatt's portfolio, the services and technology sectors are the most heavily weighted, composing 21.9% and 27.3% of his total holdings. To identify what companies Greenblatt currently views as "heavily undervalued," we must look at stocks that exhibited large swings in portfolio value between the first and second quarters of this year.

United Therapeutics (UTHR) accounts for 1.2% of Greenblatt's holdings and is the second-largest investment in Gotham Asset Management's total 13F portfolio. From the first to the second quarter of 2012, Greenblatt doubled his position in the biotechnology company, which is focused on developing products for patients who have life-threatening conditions.

As expected, United Therapeutics has been a strong performer among biotech companies. The company has experienced seven years of growth in cash profits (three years GAAP) and has been on Deloitte's list of fastest-growing companies for 11 years running. It also has the second-highest revenue per employee among its peers. It is likely that Greenblatt sees value in this biotech because of its consistent historical performance, as United Therapeutics is among the leaders in all three of its market segments. Additionally, the company has forecasted that it will hit sales of $2 billion in 2013, stemming from its late-stage pipeline of products.

From a magic-formula perspective, United Therapeutics' return on invested capital has increased every year since 2007, and it was 18.69% last year. The stock has returned nearly 16% year to date and is trading at 11.6x earnings. Moreover, the company's insiders have been particularly bullish, most notably CEO A. Martine Rothblatt. Here's a full list of Rothblatt's transactions.

Greenblatt's second-quarter 13F filings also reveal a large position in the mattress and pillow manufacturer Tempur-Pedic International (TPX). The hedge fund manager has taken an $8 million position in Tempur-Pedic; the stock accounts for 0.58% of his total portfolio's holdings.

Between April and July of this year, Tempur-Pedic released guidance figures that were below analysts' estimates. This caused the company's stock price to tumble from the $87 range in April to a low of $23 in June. During this selloff, we suspect that Greenblatt kept his emotions in check and remembered that Tempur-Pedic was still the leader in the non-spring and premium mattress market segments, in addition to being among the industry leaders in operating margin and cash flows.

Over the past three years, the company has more than doubled its return on invested capital, from 17.68% in 2009 to 38.23% in 2011. Since reporting his holdings at the end of June, Greenblatt has seen Tempur-Pedic's stock price recover by nearly 40%. Since the stock still trades at 10.4x earnings, which is far below the industry average P/E of 23.1, there looks to be more value here.

Nu Skin Enterprises (NUS) accounts for 0.40% of Greenblatt's portfolio. Greenblatt increased his position in the anti-aging personal care developer by 581% in the second quarter of 2012. Year to date, the stock has been volatile, as investors seem unsure about the company's potential. From December 2011 to March of this year, the company's stock price performed particularly well, jumping by more than 20% over this time period.

When the company raised its 2012 guidance by a less than expected amount in April, however, investors weren't impressed, and they pushed prices down 30% to the $40 mark by early May. We suspect that Greenblatt saw a bargain-bin opportunity in this particular selloff, as Nu Skin was still the same company that had increased revenue every year since 2007 and had projected 2012 revenue of $2.03 billion, up from the $1.74 billion it reported in 2011.

In addition to this growth, the company's operating and net margins have grown quite significantly over the past half-decade, while earnings have improved every year since 2007. Moreover, Nu Skin has increased its return on invested capital substantially over this time period, from 6.65% in 2006 to 22.84% in 2011.

It appears that a bit of the market's uncertainty over this stock is a result of a report from Citron Research about Nu Skin's alleged unfair business practices. The report stated that the personal-care products maker is operating an illegal multi-level marketing scheme in China. Citron believes that Nu Skin's direct-selling business in China is actually a pyramid scheme that is illegal under Chinese law.

Because of concerns over these accusations, Nu Skin is trading at a P/E ratio of 13.7x, below its five-year (17.7x) and 10-year (20.3x) historical averages. The company's earnings are also valued below those of competitors such as Avon Products (AVP) and Estee Lauder (EL), which sport P/E ratios of 27.4 and 28.3 respectively. When growth is factored into the equation, we can see that Nu Skin has a price/earnings-to-growth ratio of 0.87; typically any figure below 1.0 signals undervaluation.

To recap, Joel Greenblatt is heavily invested in these three stocks because of their consistent earnings growth and impressive returns on invested capital. Because of these two factors, each company has positioned itself to see moderate price appreciation in the next 12 to 16 months.

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