Stocks With a Little Magic

Since fund manager Joel Greenblatt published his investing tome, The Little Book That Beats the Market, in 2005, the stock market has hit historic highs and is once again exploring depths not seen since the bursting of the tech bubble.

The book marked a unique point for investors because it gave them insights into investing strategies a value investing master himself used that are also easily replicated. Greenblatt has achieved phenomenal results over the past two decades, besting even the performance of Warren Buffett.

The strategy is deceptively simple: Buy undervalued, high-performing companies and hold for a year. Rinse and repeat. But what if we can augment Greenblatt's methodology? Below we've used a "magic formula"-like screen that approximates the pre-tax earnings and return on capital criteria he lays out, but adds to it by looking for companies with top ratings of four or five stars from Motley Fool CAPS.

Over the first 20 months of tracking the collective intelligence, the data showed that newly minted five-star stocks offered the best opportunities for investors, whereas the lowest-rated companies fared the worst. A five-star rating is the highest a company can get in CAPS. Combining those rankings with the criteria that Greenblatt suggests should give us winning investments that may just produce some outsized returns.

Here are a few companies that showed up when I ran this screen recently.

Source: Capital IQ, a division of Standard & Poor's, and Motley Fool CAPS. Pre-tax earnings yield is inverse of EV/EBIT. Pre-tax ROC is EBIT divided by tangible capital employed.

Of course, we don't think you should just rely upon this list of stocks as a list of companies to buy. Due diligence on every investor's part is always a smart requirement. Yet it provides us with a narrowly focused list of companies upon which to concentrate our efforts. So, let's see what CAPS members have to say about a couple of these.

A little bit of pixie dust
Just when it looked like we had walled off our worries about contracting cancer from second-hand smoke by banishing smokers to the outer perimeters of bars, restaurants, and office buildings, the fear mongers have returned, concocting new dangers that threaten to undermine the well-being of the Republic and attack the profitability of Altria, Lorillard (NYSE:LO), and Reynolds American (NYSE:RAI): third-hand smoke! That's what you supposedly get from exposure to smoke on someone's clothes, fabric on your couch, etc. If you're still smelling smoke after the fact, then you're in danger.

CAPS member windyposter thinks that the government ought to just butt out, but notes that Altria should do well regardless of the anti-smoking crusade because of the demand for tobacco:

this is a stable stock. for anyone that has traveled extensively it will be clear that these wonderful little white sticks hang out of the mouths of the majority of people all over some of the largest nationalities and even continents on the planet. very few governments are trying...or even worried about trying to stall the continued growth of the use of this product.

Silicon wafer maker MEMC Electronics has been hit hard by the market's softening for electronics and solar panels. As the recession cuts into demand, analysts think that MEMC will need to soften a bit itself, at least when it comes to pricing, if it wants to continue seeing revenue growth.

CAPS All-Star member BSHumphreyII thinks the market has overreacted to a single earnings miss and that its financials continue to look solid:

They've been beaten to death in the last year, probably unfairly. One quarter of declining year-to-year earnings in at least the last 13 should not translate to a 4.5 P/E. Their balance sheet looks fantastic, and their returns on equity and capital are in the mid 20s - very solid. Cash flow from operating activities is trending up strongly, and with a lot of long-term sales contracts lined up, this will probably continue. There are some senile industries in the U.S. that might not recover from the recession (such as automobiles), but semiconductors are not one of them.

Beat the street
You'll need to read more than a few pages of this book to make your buy or sell decisions. So start your own research on these stocks on Motley Fool CAPS, where your opinion can still save the day. Read a company's financial reports, scrutinize key data and charts, and examine the comments your fellow investors have made -- all from a stock's CAPS page.

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