These Stocks Have a Little Magic

When fund manager Joel Greenblatt published his investing tome, The Little Book That Beats the Market, in 2005, it marked a unique point for investors. They now held insights into easily replicated investing strategies from a value investing master. As proof, Greenblatt has achieved phenomenal results over the past two decades, besting even the performance of Warren Buffett.

His strategy is deceptively simple: Buy undervalued, high-performing companies, then hold them for a year. Wash, 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, then applies those standards to companies with top ratings of four or five stars from Motley Fool CAPS.

Over the first 20 months of compiling data from collective intelligence database, we Fools found that newly minted five-star stocks offered the best opportunities for investors, while the lowest-rated companies fared the worst. 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: CapitalIQ, a division of Standard & Poor's; Motley Fool CAPS. Pre-tax earnings yield is inverse of EV/EBIT. Pre-tax ROC is EBIT divided by tangible capital employed.

Although Greenblatt's strategy is a mechanical one, we don't think you should just rely upon this as simply a list of companies to buy. Due diligence on this narrowly focused list of companies is always a smart requirement. So, let's see what CAPS members have to say about a couple of these.

A little bit of pixie dust
Few people expect we'll be able to enjoy these depressed oil prices for very long, and some investors believe Vaalco Energy will benefit from the turnaround. Using the Adriatic VI jackup rig from Transocean (NYSE:RIG), Vaalco has been digging around its Ebouri field off the coast of Africa, expanding its boundaries and reserves. It has substantially enlarged the productive acreage there, allowing it to enhance its recoverable reserves. As a result, CAPS member johnnyb39 expects resurgent oil prices to lead to even greater exploratory efforts by the oil company:

Expect oil prices to go up in 2009 and [Vaalco] to bring you profits from the need to drill oil. Oil exploration will pick up in the 2nd qtr of this year and continue out for several years.

Stealing opportunities
Downloadable content packs, or DLCs, may be a boon to Take-Two Interactive and the bane of GameStop (NYSE:GME), but analysts aren't completely convinced of their power. Expanding upon its wildly popular Grand Theft Auto franchise, Take-Two has now pinned its most recent hopes on two upcoming downloadable additions, available to Xbox 360 gamers. If the format proves successful, it may serve as a serious challenge to GameStop's bricks-and-mortar retail model.

Yet at least one analyst thinks Take-Two won't generate enough revenue from the DLCs, because not nearly enough copies of the GTA game were sold to Xbox Live subscribers to make a difference. Wedbush Morgan says Take-Two received $50 million up front for GTA IV, and needs to wait until DLC generates $35 million in sales (approximately 1.8 million copies) before it will receive any more revenue.

CAPS member dirkness isn't worried. This member sees GTA morphing into a massively multiplayer online game experience similar to World of Warcraft:

It is likely that [Take-Two Interactive] will produce at least two more best selling games on this engine (as it did with the GTA III engine) each with it's own additional DLC, before developing an MMO. However, when this next edition of GTA becomes available it will not only be another top selling game for [Take-Two Interactive], but it will be the dominate console MMO and generate a constant flow of subscription revenue.

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. While there you can 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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