We recently compiled a list of the 10 Best Magic Formula Stocks For The Rest Of 2024. In this article, we are going to take a look at where Microsoft Corporation (NASDAQ:MSFT) stands against the other magic formula stocks.
One of the best known investment strategies on Wall Street, and one that’s also followed by investing greats the like of Warren Buffett of Berkshire Hathaway and Seth Klarman of Baupost Group is value investing. Another fund manager who has delivered fantastic returns through a value based approach is Joel Greenblatt. Greenblatt currently runs the hedge fund Gotham Asset Management, a fund that he set up in 2008 after moving forward from his previous fund called Gotham Capital.
Greenblatt is among the fund managers that have consistently delivered double digit percentage returns during their career on Wall Street. His previous firm, Gotham Capital, had an amazing run between 1985 and 1994. During this time period, the firm delivered a net return of 34%. This was particularly impressive, as 1985 was the year in which Gotham Capital was founded. On an annualized basis, the fund’s returns were even stronger, since during the same period, Greenblatt’s fund delivered 50% in returns.
The hallmark of a value investing strategy, as you’ll understand if you study Warren Buffett’s investment strategy in detail, is patience. This also applies to Greenblatt, who typically waits for at least a couple of years after making an investment to reap the returns. But while patience might be a virtue, on Wall Street, it’s the returns that matter. On this front, Greenblatt hasn’t disappointed, as his fund’s blazing run in the 1980s wasn’t its only one. After setting up Gotham Asset Management in 2008, the value investor managed multiple funds. Two of these were the Gotham Absolute Return (AR) fund and the Gotham Neutral fund. Among these, the AR fund was set up in 2012, and between then and 2018, its returns sat at 58.6%.
However, while these returns are impressive, this period was filled with ups and downs for the investment vehicle. For instance, 2013 was one of the best years for this fund as it posted 29.82% in returns. These gains were trimmed down to 9.31% in 2014. While these weren’t as strong as the previous year’s performance, they were nevertheless in the green. This is important since the next year wasn’t great by any account, since in 2015, the AR fund ended up with -10.25%. 2016 was somewhat turbulent for American stock markets since the Brexit vote in the UK, slowing Chinese GDP growth, and a commodities slump led to US and global stocks dipping between the end of 2015 and the first half of 2016. Between June 2015 and late February 2016, the blue chip Dow index had lost roughly 9% and the broader NASDAQ had bled a much higher 11%.
The next year would see Greenblatt bounce back. In 2016, the fund delivered 7.97% in returns and accelerated its performance later on through posting 10.03% in gains. During these same years, i.e., in 2014, the Gotham Neutral fund’s annualized returns had sat at 6.83%.
Since the onset of the coronavirus pandemic in late 2019, the stock market has been operating in a changed environment. The pandemic’s immediate aftermath saw major stock indexes crash by 30%+, which then led to the Federal Reserve reducing rates to near zero levels. The subsequent low cost of capital, the boom in demand for consumer technology products, and the rise in retail investing then saw markets soar. During this time period, i.e., the bottom in March 2020 and the peak of December 2021, Greenblatt’s AR fund was up by 55% while the flagship S&P index gained 103%. This might make you think that perhaps the investor, who calls his investment approach a ‘Magic Formula’ had lost its magic.
But you’d be wrong. The magic of the Magic Formula was visible during the next phase of the stock market. This was marked by the Federal Reserve’s rapid interest rate tightening cycle that came in response to soaring inflation. Between December 2021 and October 2023, inflation continued to rise, as the interest rates took their sweet time to make a mark. This meant that the flagship S&P was down by 13.6% from 2021 close to the end of October 2023.
However, during the same period, the AR fund had gained 3.41%. A short strategy had helped Greenblatt, it seems, as the AR fund advertises itself as being 50% to 60% net long. Gotham’s pure play long fund, which is 100% long, led the S&P in losses during this time period as it had lost 15.52% during the same period and a stronger 27% from its peak in November start. However, the magic was visible between the March bottom and the November 2021 peak as during this period the 100% long fund had gained 97% to nearly match the flagship index.
Before we head to our list of the best Magic Formula Stocks, it’s also important to take a brief look at what this investment technique entails. Greenblatt’s strategy is based on two metrics, the return on capital employed (ROCE) and the earnings yield. In a simple implementation, stocks are ranked according to these metrics, and the top stocks are bought and held for the long term. A specialty implementation is what Gotham calls its Gotham Yield. According to the fund, this is a proprietary technique that assesses a firm’s “pre-tax cash flow, return on capital, and enterprise value.”
Our Methodology
To make our list of the best magic formula stocks to buy, we ranked the stocks present in Gotham Asset Management’s Q2 2024 SEC filings by their dollar value and picked out the most valuable holdings.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A development team working together to create the next version of Windows.
Microsoft Corporation (NASDAQ:MSFT)
Number of Hedge Fund Investors In Q2 2024: 279
Gotham Asset Management’s Q2 2024 Stake: $95.3 million
Microsoft Corporation (NASDAQ:MSFT) is the mega cap technology giant that is one of the biggest players in the cloud computing industry as well as personal computing. Microsoft Corporation (NASDAQ:MSFT)’s Windows powers up most of the world’s computers, while Azure is believed to control 26% of the global cloud computing market. Like other big tech firms, it has access to its own foundational model, through partner firm OpenAI’s ChatGPT. OpenAI’s brand status as the firm that popularized AI also allows Microsoft Corporation (NASDAQ:MSFT) to benefit from the association. This is key to the firm’s future especially as it plans to market AI products to enterprise customers through cloud computing. The central tenet of Microsoft Corporation (NASDAQ:MSFT)’s hypothesis these days is its ability to monetize AI especially since it has plowed billions of dollars into the technology. In fact, after its Q2 earnings, Microsoft Corporation (NASDAQ:MSFT)’s shares tanked by 8% as it revealed that Azure growth had slowed to 29% from an earlier 31%––which cast doubts on its ability to add tailwinds from AI services.
The stock began to recover though as Microsoft Corporation (NASDAQ:MSFT)’s shared during the earnings call:
“For Intelligent Cloud we expect revenue to grow between 18% and 20% in constant currency, or US$28.6 billion to US$28.9 billion. Revenue will continue to be driven by Azure which, as a reminder, can have quarterly variability primarily from our per-user business and in-period revenue recognition depending on the mix of contracts. In Azure, we expect Q1 revenue growth to be 28% to 29% in constant currency. Growth will continue to be driven by our consumption business, inclusive of AI, which is growing faster than total Azure. We expect the consumption trends from Q4 to continue through the first half of the year. This includes both AI demand impacted by capacity constraints and non-AI growth trends similar to June. Growth in our per-user business will continue to moderate.
And in H2, we expect Azure growth to accelerate as our capital investments create an increase in available AI capacity to serve more of the growing demand. In our on-premises server business, we expect revenue to decline in the low single digits as continued hybrid demand will be more than offset by lower transactional purchasing. And in Enterprise and partner services, revenue should decline in the low single digits. In More Personal Computing, we expect revenue to grow between 9% and 12% in constant currency, or US$14.9 billion to US$15.3 billion. Windows OEM revenue growth should be relatively flat, roughly in line with the PC market. In Windows commercial products and cloud services, customer demand for Microsoft 365 and our advanced security solutions should drive revenue growth in the mid-single digits.”
Overall MSFT ranks 2nd on our list of the best magic formula stocks to buy. While we acknowledge the potential of MSFT as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than MSFT but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.
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