The safest and most reliable path to stock market success is to invest in CRAP stocks.
The strategy we follow, Joel Greenblatt's Magic Formula? Investing (MFI), is a great mechanical, qualitative screen for digging up candidates. But to find the CRAPpiest of stocks, we need to get our hands dirty and dig our noses into the financial statements, conference calls, SEC filings, and industry research. Only then can our portfolios come out smelling like roses.
What in the heck am I talking about? 4 points of research:
Conservatively managed
The best companies are managed conservatively, and are always focused on earning high returns on capital instead of overpaying simply to grow or build an empire. By maintaining reasonable levels of debt and always having a healthy cash balance for the inevitable bumps in the road, these companies are built to last through thick and thin.
How can you tell if a company is conservatively managed? Firms that have zero or very little debt (like Dolby (DLB), or Activision (ATVI)) are more conservative than Ann Coulter on a Sunday morning. But, in general, be wary of firms that carry significantly more debt than cash on the balance sheet or whose operating earnings do not cover interest obligations more than 5 times over. An example of a company managed too aggressively would be FriendFinder (FFN), with $460 million of debt, only $17 million in cash, and operating earnings that barely cover 70% of interest obligations!
Revenue growth
Firms can always improve profitability through expense cutting, and stock multiples can ebb and flow, but ultimately a company must grow its sales in order to expand its bottom line sustainably. Revenue growth is catnip for money managers, and few stocks can maintain a high price/earnings multiple without it. MFI does not look for it, so many screened stocks have flat or declining sales - see Apollo Group (APOL) or H&R Block (HRB). Not coincidentally, the stocks of these firms have the most limited upside potential.
On the other hand, finding an MFI stock with good revenue growth trends could very well indicate that the market's valuation has trailed the company's growth trajectory, creating an attractive investment candidate. This is especially true if rapid sales growth is projected to continue.
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