In his 2005 bestseller “The Little Book That Beats the Market,” Joel Greenblatt (Trades, Portfolio) introduced the investing world to the Magic Formula, a simple mathematical formula to find profitable businesses that trade at bargain prices.
The formula ranks companies primarily based on two metrics: earnings yield and return on capital. Greenblatt defines the earnings yield as earnings before interest and taxes (Ebit) divided by enterprise value; this metric measures how much the company earns compared to how much the stock is valued by the market. The return on capital, meanwhile, is calculated as Ebit divided by the sum of net fixed assets and net working capital and measures how much a company earns compared to what it spends to produce those earnings.
One way that investors can search for stocks based on Greenblatt’s Magic Formula is through the GuruFocus Magic Formula Screener. However, those wanting to combine the Magic Formula with other criteria may find the GuruFocus All-in-One Screener more helpful. For example, I used the All-in-One Screener to search for stocks with high earnings yields and returns on capital that also have high guru ownership. Let’s take a look at some of the guru favorites I found using this method.
Pfizer
Pfizer Inc. (PFE, Financial) is a New York-based multinational biopharmaceutical company. Its main areas of research are internal medicine, inflammation and immunology, oncology, rare diseases, vaccines and anti-infectives.
The company has become well-known in recent years due to its Covid-19 vaccine that was developed in partnership with BioNTech (BNTX, Financial). However, investors have been fearing that declines in Covid-19 cases may mean decline is imminent for Pfizer.
Just like other backwards-looking metrics, the ones used in the Magic Formula are also susceptible to success being temporary. As of this writing, Pfizer has an earnings yield of 13.97%, which is higher than 89% of industry peers, and a return on capital of 209.71%, beating 97% of industry peers. However, historically, the company’s earnings yield traded around 50% to 100% before the pandemic, while its earnings yield was in the low single-digits. Thus, it is clear Pfizer will need a way to make up the gap from Covid-19 revenues before it can attract investor enthusiasm.
Despite declining Covid-19 sales, there were still 27 gurus who owned shares of Pfizer as of the most recent 13F reports for the first quarter of 2023, which ended on March 31. The top guru shareholder was the Vanguard Health Care Fund (Trades, Portfolio), followed by Jim Simons (Trades, Portfolio)’ Renaissance Technologies and Diamond Hill Capital (Trades, Portfolio).
Investors should be aware 13F reports do not provide a complete picture of a guru’s holdings. They include only a snapshot of long equity positions in U.S.-listed stocks and American depository receipts as of the quarter’s end. They do not include short positions, non-ADR international holdings or other types of securities. However, even this limited filing can provide valuable information.
With a robust pipeline, it may be too soon to count Pfizer out when it comes to the potential to develop new blockbuster drugs. The stock also trades at a discounted price-earnings ratio of 7.6 and has a dividend yield of 4.22%.
Cisco Systems
Cisco Systems Inc. (CSCO, Financial) is a multinational technology company and worldwide leader in IT, networking and cybersecurity solutions. Based in San Jose, California, the company develops, manufactures and sells networking hardware, software, telecommunications equipment and other tech products.
The company has been seeing a recovery in growth due to its cybersecurity business. Cybersecurity is becoming more important than ever due to the ongoing technological shift to the cloud, which exposes data to security risks around the world. Approximately half of Cisco’s revenue comes from its secure and agile networks segment, which provides things like data switches, enterprise routers and wireless products.
The company has an earnings yield of 7.63%, which is higher than 69% of industry peers. The return on capital of 731.7% is much more impressive, beating 99% of other hardware companies. The earnings yield is fairly average compared to the company’s historical levels, and while the return on capital is higher compared to historical averages, it has been on a consistent uptrend since 1992, showcasing decades of steady improvements in profitability.
There were 26 gurus who held shares of Cisco as of the latest 13F reports for the first quarter. The top guru shareholder of the stock was Dodge & Cox, followed by Primecap Management and the Parnassus Value Equity Fund (Trades, Portfolio).
While Cisco is primarily a hardware company for now, its growing cybersecurity business could potentially draw higher valuations if it someday makes up a bigger portion of revenue. As of this writing, the stock trades at a price-earnings ratio of 18.14. The dividend yield is a solid 3.06%.
Qualcomm
Qualcomm Inc. (QCOM, Financial) is a multinational semiconductor company based in San Diego. Its main focus is on communications technology, particularly for use in smartphones, 5G and artificial intelligence. It is perhaps best known for its widely used cellular modems.
The company is seeing increasing demand for its wireless and high-performance, low-power processor technologies. Due to its patents, the company profits from virtually every smartphone sold, even if said phone does not use Qualcomm’s chips. However, Apple (AAPL, Financial) is planning to start transitioning away from Qualcomm’s modem chips that it uses in iPhones in favor of its own in-house chips as early as 2024, which is a headwind that cannot be ingored.
Qualcomm’s earnings yield of 8.82% outperforms 78% of industry peers, while its return on capital of 156.01% is better than 95% of other semiconductor companies. Both of these figures are fairly consistent with the company’s averages ever since the recovery from the financial crisis in 2008, which is both good and bad. On the positive side, the company has proven its ability to be consistently profitable, but on the downside, it is not in a consistent uptrend. In 2018, the return on capital fell all the way to 37%.
A total of 25 gurus held the stock as of the latest quarterly reports, with the most notable being Primecap Management, the T. Rowe Price Equity Income Fund and Barrow, Hanley, Mewhinney & Strauss.
Even with the loss of Apple, Qualcomm may still be able to make up the difference given the expected growth of the semiconductor industry related to artificial intelligence. As of this writing, the stock trades at a price-earnings ratio of 12.32 and offers a dividend yield of 2.67%.
