5 Stocks With a Little Magic

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When fund manager Joel Greenblatt published his investing guide, The Little Book That Beats the Market, in 2005, it marked a unique point for investors. They now had in their hands insights into investing strategies that a value investing master himself used and that are also easily replicated. As proof, 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. 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, but adds to it the ratings from our Motley Fool CAPS investor intelligence database. 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.

Stock	Pre-Tax Earnings Yield %	Pre-Tax Return on Capital %	Recent Stock Price	CAPS Rating
Endo Pharmaceuticals (Nasdaq: ENDP)	22%	>100%	$16.51	*****
Graham (NYSE: GHM)	28%	>100%	$13.17	*****
EMCOR (NYSE: EME)	25%	>100%	$23.35	****
Formula Systems (Nasdaq: FORTY)	88%	>100%	$7.30	**
Pre-Paid Legal Services (NYSE: PPD)	23%	>100%	$42.96	*

Source: Capital IQ, a division of Standard & Poor's; Motley Fool CAPS. Pre-tax earnings yield is the 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 simply rely on this as 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 one of these magical companies.

A little bit of pixie dust
Should you end up in a legal bind, having a go-to lawyer provides peace of mind to many people. Pre-Paid Legal Services offers basic access to legal advice through its network of independent law firms at a cost of $15 to $25 a month, a rather affordable price considering that just an hour's worth of a lawyer's time can easily run $100 or more.

What turns many investors off to Pre-Paid Legal, however, is that it markets its services through multilevel marketing (MLM) techniques. Because some of these marketing plans have been little more than scams, legitimate businesses that use multilevel marketing, such as Mannatech (Nasdaq: MTEX) and USANA Health Sciences (Nasdaq: USNA), have been tarred with the same broad brush and come under closer scrutiny.

Whatever the merits (or demerits) of MLM, Pre-Paid Legal is suffering from an erosion of its membership base. In its latest quarter, new legal memberships decreased 10.8%, while new identity theft memberships plummeted 40.5% from the year-ago period. At the end of the quarter, it had over 1.4 million active members, but it actually lost about 160,000 members compared to the year-ago quarter. In the most recent quarter, it sold 117,000 new memberships -- not enough to fully offset the attrition, leaving it net 43,000 fewer members in total.

Pre-Paid Legal faced a similar trend last year, losing more than half a million members over the course of the year, but replacing them with not quite as many, ending down a net 23,000. That's quite a level of customer churn, bringing to mind some of the worst descriptions of MLM as a Ponzi scheme that requires ever-greater numbers of people to be brought into the circle.

While that has been a criticism of MLM in general, and of Pre-Paid Legal in particular, by the private Fraud Discovery Institute, a number of investors don't see it that way. CAPS member bcnu6, who self-identifies as a former attorney in Pre-Paid's lawyer network, says the company is no Ponzi scheme. This CAPS member says that those who contend that Pre-Paid is on its deathbed don't realize that many of its members would be loath to give up their coverage:

While there may be grounds for objection to that part of the business model which uses "Independent Associates" to hawk its services, this is in no way a ponzi scheme as many fools assert in their pitches. And while there may be grounds to question whether the customers truly obtain good value for their monthly payments, the typical customer would be loathe to give up their coverage. The typical customer may be one who prone to be intimidated by lawyers and who feels vulnerable in the face of persons and institutions perceived as more powerful. Pre-Paid Legal tends to reassure these people that they can obtain assistance in the face of trouble, and eases the task of finding an attorney to help.

Since hitting its 52-week low back in April, Pre-Paid's stock has rebounded by more than 50%, giving investors something with which to thumb their noses at naysayers.

Beat the Street
While he's provided an interesting magic formula, you'll need to read more than a few pages of Greenblatt's 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.