alengo/E+ via Getty Images

alengo/E+ via Getty Images

Magic formula investing is based on Joel Greenblatt's popular investing book, The Little Book That Beats the Market. Not long after the book was published, Joel Greenblatt's team created a free stock screener that would trawl for stocks that were both cheap and good, based on metrics described in the book.

The top stock by the score for the month in the large-cap segment of the stock market is Nucor (NYSE:NUE ), one of the United States' oldest and largest producers of various steel products. Even though steel prices have been sinking as of late, the company has maintained a relatively healthy chart, even though the last recession. This is a very efficient operator with high returns on invested capital, low debt, and increasing free cash flow. My thesis is this stock is a buy, especially accumulating into the weakness that the overall stock market is presenting.

In 1985, Greenblatt started a hedge fund, Gotham Capital, with $7 million, most of which was provided by "junk-bond king" Michael Milken. Robert Goldstein joined Gotham Capital in 1989. At Gotham Capital between 1985 and 1994, Greenblatt presided over an annualized return of 50% "after all expenses" but "before general partner's incentive allocation" fees; or 30%, net of all fees.) Gotham specialized in "special situations" like spinoffs and other corporate restructurings". In January 1995 Gotham returned all capital of outside partners (approximately $500 million).

Joel Greenblatt was also the original funder of Dr. Michael Burry's Scion Asset Management, discovering him through his blogging activities. He is currently a professor at Benjamin Graham's alma mater, Columbia University, and runs a hedge fund called Gotham Asset Management. He has produced two investment classics, the first being You Can be a Stock Market Genius and the latter being the Little Book.

The metric used in Magic Formula/Little Book investing is quite simple, it takes all the stocks in the stock market, minus banks and utility companies (since their growth is regulated) and scores them by combining their earnings yield and their return on invested capital. The two percentages are added together and a score is derived from this. The earnings yield is calculated by dividing the earnings per share by the share price. He believed the earnings yield gives a better metric than P/E as values more positive are better, while in P/E a value of smaller proportions is better when analyzing the "cheap" part of the equation. There must be two "positive is better" metrics to add together to produce ascending scores.

The earnings yield is then added to the ROIC %. An example would be a stock with an EPS of $10, and a share price of $100. $10/$100= 10% earnings yield. This would then be added to the ROIC. If ROIC was also 10%, then the stock would have a total score of 20. The higher the score the better. The screener allows you to set the market cap threshold from $50 million up to infinity. I prefer to set the screener at $12 billion and up as this will screen companies that have more institutional support and ones that are most likely members of the S&P 500.

The below list is the top 30 scored stocks for September with market caps over $12 billion, since the requirement is $13 Billion to enter the S&P 500, this gives me a little buffer since some of the stocks in the index drop below that market cap threshold after entering:

As we can see, both Nucor and Steel Dynamics (STLD), scored highest with Nucor edging them out slightly. This excel list is imported from Magicformulainvesting.com. The site does not give actual scores, just a list. I went through the process of calculating the scores based on earnings yield using EBIT/EV (this has been posited as the true formula the software uses, but the methodology has not been disclosed) combined with ROIC values from a well-known brokerage. If your screeners do not provide ROIC, Greenblatt advises ROA can be a good substitute. All numbers on my spreadsheet are in Billions.

One anomaly I had to revise was the ROIC of Hewlett Packard (HPQ), it is consistently showing an ROIC of more than 100% on several websites and the mentioned brokerage. Therefore I deferred to ROA instead. With the current way Hewlett Packard is reporting ROIC, it is screening as the highest total score in the entire stock market.

With both Nucor and Steel Dynamics both clocking a TTM ROIC of 38%, this is an industry that is clicking on all cylinders. The China construction slowdown has been happening for some time, without much in the way of earnings revisions for Nucor. Can the party last? Is Nucor's business resilient enough to operate at these profit levels going into a recession?

Nucor against peers (seeking alpha)

Nucor against peers (seeking alpha)

In addition to the high magic formula non GAAP adjusted score for Nucor of 76.9, we can also see the business is trading at a discount to sector valuations across the board. This is not because the stock has cratered, but because their earnings and sales are just that much better. One of the big benefits for Nucor came when steel mill utilization fell during COVID and Nucor was able to increase capacity to meet demand, absorbing more business.

Nucor is a beneficiary of using a large supply of scrap metal for their steel feedstock, reducing exposure to overall steel input price fluctuations and inventory write-downs that occur if the feedstock is held in excess when prices drop. The company's furnaces are mainly electric arc, providing some cost benefit to the company versus blast furnaces utilizing expensive petroleum inputs. The company's main competition are:

Econiq is a catalyst for Nucor that CEO Leon Topalian says will put them over the top versus its competitors. The product is described as follows from Nucor's Econiq product page:

Econiq is the world's first net-zero steel at scale, produced by Nucor. Econiq is not a single product; it is a net-zero certification, which can be applied to any product from Nucor's steel mills.

I must say this product intrigues me the most from Topalian's on-air and conference call comments. Nucor is a first mover in steel trying to create a green product to obtain tax credits. This could put an entirely new spin on the boom and bust nature of the steel business if subsidization of efficient production could be obtained.

In 2020 and 2021, we entered into three Virtual Power Purchase Agreements ("VPPAs"). Under each VPPAs, we have agreed to purchase for a fixed price a portion of the output of both solar and wind renewable power projects being developed in the United States. The VPPAs will be settled financially on a monthly basis. We have undertaken these initiatives to support the ongoing transition of the U.S. power grid to a greater reliance on renewable power. As part of these arrangements, we will also receive Renewable Energy Credits ("RECs") commensurate with the power we purchase.

These RECs can be applied against a portion of our GHG emissions, enabling us to receive credit for reducing them. The pay fixed, received floating nature of this arrangement also offsets a portion of our exposure to higher prices for electricity over the life of the contract. We are evaluating and considering similar transactions. One VPPA started delivering RECs to us in June 2021 and the other two VPPAs may be delayed as a result of supply chain disruptions and permitting delays and interconnection delays. - Nucor 2021 10-K

Nucor could be falling into the perfect storm. They've prepared to make many of their operations electric, in part powered through renewable energy. All the while the cost of petroleum products to stoke blast furnaces has risen around the world. If this works, they might even start realizing cost advantages over foreign counterparts in less environmentally regulated countries.

Nucor sales segments (Nucor 10 K )

Nucor sales segments (Nucor 10 K )

Here we can see Service Centers make up the largest proportion of their sales followed by construction. CEO Leon Topalian has expressed the importance of organic growth and the continuance of Nucor to reinvest in the business and grow it even in the face of a recession. New sheet mills are planned in West Virginia by 2023-24. While construction and service center revenues may take a hit in a prolonged recession, Topalian has indicated strong demand from Automotive and energy-related segments, where they provide large anchor plates for wind turbines and will receive credits for energy and net zero steel. Industrial, non office/ residential construction should remain resilient as well.

The compounded growth rate in revenue quarter over quarter from 12/32/21 until MRQ has grown at 4.3% per quarter. Again, an unexpected result with a slowdown in residential construction. I would also like to point out that even though residential construction is slowing, the type of commercial construction involving warehouses and manufacturing still has a strong footing. Just in the semiconductor sector alone, there are hundreds of billions of planned US-based fabrication centers in the pipeline. An equivalent amount of EV battery plants are also in the works. EV automotive plants which are separate from battery plants are another industrial construction opportunity. Data center construction growth should also continue.

With this article being centrally evaluated on the Magic Formula, we can see that Nucor is a company with exceptional returns on invested capital and a high earnings yield based on both EBIT and GAAP earnings metrics. The TTM EPS for Nucor is $32.33 a share with a share price of $105 a share at the time of this article. That gives us an earnings yield of 30.7%! With increasing revenue, but forward guidance that is not as positive as in the past, there are still plenty of opportunities to maintain an earnings yield above 20% for the foreseeable future.

With the return on invested capital at 38.9%, that gives us a total score based on the traditional GAAP method of The Little Book strategy of 69.6. Scores above 20 are considered solid, which would indicate an average combination of an earnings yield of 10% and ROIC of 10%. Taking this into consideration, we can see that Nucor is currently running a score almost 3.5 X higher than the average "good and cheap" company.

Topalian believes it is unfair to be trading in the 3-4 X earnings range, they should be in the 9-10-12 X earnings range. This is the CEO's stated goal to achieve both through organic growth and returns to shareholders in the neighborhood of 40%, with TTM FCF of over $7 billion, this could lead to dividend increases and share buybacks and possible increases in EPS. If Nucor traded even at 10 X earnings, with an EPS of $32 a share, that's a $320 stock.

Nucor balance sheet (yahoo finance)

Nucor balance sheet (yahoo finance)

The debt position of Nucor is conservative and the company maintains an investment grade rating. With a debt-to-equity ratio of only 42%, the company operates on the conservative side. Debt has been increasing YOY, and Topalian has expressed the desire to continue to borrow to expand the business in what he believes is the company's growth opportunities, mainly green energy and automotive segments. The improvement and expansion of their Econiq net zero steel project plus new steel mill expansion are all growth initiatives.

From Nucor's most recent 10-K:

Nucor has invested significant capital in recent years to expand our product portfolio to include more value-added steel mill products and capabilities, improve our cost structure, enhance our operational flexibility and increase our exposure to markets with attractive growth prospects; such as data centers, warehouses and renewable energy. These investments totaled approximately $6.34 billion over the last three years, with approximately 75% going to capital expenditures and the remainder going to acquisitions. We believe that these investments will help us deliver profitable long-term growth.

An interesting tax strategy that Nucor is implementing going forward has to do with its obligations to buy renewable energy for a fixed price from the grid. These are done through Virtual Power Purchase Agreements. The energy price is fixed for a period through contracts and not subject to surges. Nucor will also in turn benefit through renewable energy credits that will solidify their free cash flow. This is a growth initiative that can only be carried out if the majority of your blast furnaces are electric arc versus coal or gas powered.

An additional point about the net zero steel product they are producing is the 10-K indicates that Nucor themselves will be the authority on what is and isn't net-zero certified. It seems that since Nucor is a large, first mover in this, they are being granted wide authority in branding their products and applying for even more tax credits by the certifications. They might even create a patentable process from this that could be sold to the entire steel industry. Executing these ESG-related initiatives and getting into the media spotlight for changing the industry could be fantastic catalysts to get the company trading in a normal 10 X earnings range.

Special dividends and large buybacks would be another. If free cash flow continues to follow its current trajectory, large returns to investors could be expected, if not demanded.

The company pays a forward 1.89% dividend of $2.00 a share. The current dividend liability is only $544 million for the next year. With free cash flow at $7 billion TTM, this is a dividend coverage of nearly 14 X. Jim Cramer recently poked and prodded Topalian to declare a special dividend since he owns the stock in his charitable trust. With this kind of coverage, a special dividend could be declared with plenty left over to execute growth initiatives. Buybacks should also be on the table big time with this kind of excess cash.

This is the top stock that screens out on Magic Formula Investor for large caps over $12 Billion in market cap in September. With a GAAP score of 69.6 and a non-GAAP EBIT/EV adjusted score of 76.9, this is 3-4 X higher than the standard score. If earnings hold up through this recession and Topalian executes to make this a net zero steel ESG leader, this could be a 2-3 bagger. Buy with a price target on the lowest end of Topalian's goal of 9 X EPS, or $288 fair value.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of NUE, HPQ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.