Joel Greenblatt (Trades, Portfolio) is a legendary value investor who created the “Magic Formula," which is a systematic investing strategy that involves picking a series of stocks with both “quality” and “value” characteristics. Quality is determined by return on capital, whereas value is determined by earnings yield. Using the Magic Formula screen on GuruFocus, which is based on Greenblatt's formula, I was able to further refine my Magic Formula search to only U.S. stocks which are in the technology sector and trade at a large market capitalization. Two of my favorite stocks that meet these criteria are Qualcomm (QCOM, Financial) and Cisco Systems (CSCO, Financial); let's take a closer look at these quality and value stocks.
Qualcomm
Qualcomm (QCOM, Financial) is a semiconductor chip giant that specializes in cutting-edge wireless technology products and services, from designing semiconductors and telecommunications equipment to developing system software for smartphones and tablets. The company is at the cutting edge of wireless innovation, with over 140,000 patents across areas such as 5G and the internet of things.
Qualcomm has a return on capital of 202.58%, which is fantastic. Its earnings yield is also a solid 9.97%.
The company is most famous for producing the Snapdragon, which is the ultimate all-on-one chip. It includes multiple processors, GPUs and cellular connection features such as 5G. All these components are tied together in a "compact, high performance and energy-efficient package."
Therefore, it should come as no surprise that this product powers 70% of the latest Samsung (XKRX:005930, Financial) Galaxy S23 model. In addition, Samsung has expanded its deal with Qualcomm up until 2030, which offers great consistency for investors. The Samsung Galaxy series makes up ~24% of total phones sold in the Western world, which is second to Apple (AAPL, Financial) which has ~50% market share, according to data from Counterpoint Research. Apple is also a customer of Qualcomm for its modem chips, though this agreement is likely ending as Apple aims to design more of its own chips in house. We have already seen this with the Apple M1 and M2 processors in the latest MacBook pro series, which replaced the Intel (INTC, Financial) processors.
Mixed financials
Qualcomm reported mixed financial results for the first quarter of its fiscal year 2023. Its revenue was $9.46 billion, which declined by ~12% year over year and missed analyst forecasts by ~$190 million.
This may seem terrible at first glance, but keep in mind this has been driven by a cyclical decline in the semiconductor industry as a whole. In addition, weaker handset sales have been the result of mainly the macroeconomic environment. These headwinds are forecast to continue into the first half of 2023, as elevated inventory levels are passed through gradually.
A positive for Qualcomm is its Internet of Things (IoT) segment continued to grow its revenue by 7% year over year to $1.7 billion. IoT basically refers to internet-connected devices that have become ubiquitous in our lives. These devices can range from smart speakers to smart security cameras and much more.
According to Fortune Business Insights, the IoT industry was valued at $478 billion in 2022 and is forecast to grow at a rapid 26.4% compound annual growth rate (CAGR), reaching a value of ~$2.5 trillion by 2029.
Qualcomm also reported blistering growth in its automotive segment, which increased its revenue by 58% year over year to $456 million. This was driven by the Snapdragon-focused “Digital Chassis," which partners with manufacturers such as Ford (F, Financial).
Moving on to profitability, Qualcomm reported solid earnings per share of $1.98, which beat analyst forecasts by $0.03.
The company also has a strong balance sheet with $8.4 billion in cash and short-term investments compared to total debt of $16.8 billion, of which $15.4 billion is long-term debt.
Valuation
The company trades at a price-earnings ratio of 11.40, which is 25% cheaper than its five-year average.
The GF Value chart indicates a fair value of ~$179 per share and thus the stock is “significantly undervalued” at the time of writing.
Cisco Systems
Another Magic Formula stock I like is Cisco Systems (CSCO, Financial). Cisco is a legacy technology company that specializes in designing and manufacturing networking equipment. The company supplies the hardware which effectively creates the “backbone” of the internet. Its products include routers, switches and access points for IT networks.
Cisco has a super return on capital of 716.33% and a great earnings yield of 7.51%.
Transforming business
Cisco is currently going through a business model transition from hardware-focused to software focused. I believe this will be positive in the long term, as software companies tend have higher margins and greater operating leverage. As the transition continues, Cisco has continued to produce solid financial results.
In the second quarter of its fiscal year 2023, Cisco reported $13.59 billion in revenue, which beat analyst forecasts by $179 million and increased by 6.8% year over year. Its software revenue expanded by 10% year over year, while its subscription revenue increased by 15% year over year.
Cisco’s recurring revenue has now reached 44% of total revenue, which is fantastic and offers great consistency for investors. In addition, the company has built up a staggering $32 billion in remaining performance obligations.
Moving on to profitability, the company reported non-GAAP earnings per share of $0.88 in the quarter, which beat analyst forecasts by $0.02, which was a positive sign.
In addition, the company has a strong balance sheet with $22 billion in cash and short term investments compared to total debt of ~$9.957 billion, of which $7.68 billion is long-term debt and thus manageable.
Valuation
The company trades a price-earnings ratio of 18.43, which is 18% cheaper than the IT sector average.
The GF Value chart indicates a fair value of ~$52 per share, making the stock "fairly valued" at the time of writing.
Final thoughts
Both Qualcomm and Cisco are tremendous technology companies that have many tailwinds ahead. Cisco is a legacy technology company that is executing its business model transition extremely well so far. Qualcomm is poised to benefit from the forecasted growth in the 5G industry. Both stocks tick the Magic Formula’s boxes for quality and value as well.
