These Stocks Will Beat the Market

Forget get-rich-quick schemes. Even get-rich-slow methodologies can lose you serious money.

That's why most investors are best served by index funds and ETFs.

But for those of us who want to beat the market, there's one very simple stock picking method that can make us serious money. Read on, and I'll tell you about the method and share some resulting stock picks.

Why I think it'll work
We listen to folks like Warren Buffett and Peter Lynch because (1) their track records are amazing, and (2) their advice makes intuitive, common sense.

Buffett has averaged around 20% returns for half a century. Lynch averaged almost 30% returns for more than a decade. The guy whose stock picking method I'm going to tell you about has averaged about 40% during his run!

And his advice is actually more actionable than the general principles espoused by Buffett and Lynch. In fact, he tells you exactly which stocks to pick. I'll reveal some of my favorites later, but first, the methodology.

The stock-picking method
Joel Greenblatt's stock-picking method is heartbreakingly simple for those of us who pore over 10-Ks, follow each minor press release, and build large spreadsheets and financial models to find undervalued stocks.

In his book, The Little Book That Beats the Market, he masterfully explains the basic principles behind his market-thrashing success.

It boils down to just two things. Find stocks with:

  1. high earnings yields, and
  2. high returns on capital

Think about that for a second. Earnings yield is just how much the company makes versus how much you pay for the stock. And return on capital is just how much the company makes versus how much the company pays for its business.

And it's all just on the last year's performance. No need for analyst growth estimates or dissecting the future viability of the business. In its simplest version, you just rank stocks over a certain size (say $50 million or $5 billion) on these two metrics and pick the top 20 to 30 stocks.

Why you won't follow it
Really? That's it? Basically, yes. I'm leaving out some of the gory details you'll want to read about before executing the strategy, but it's that simple. There's a catch, though. The catch is you probably won't follow it.

You read that right. Even if you buy what I'm writing, read Greenblatt's book, and try it for yourself, you probably won't stick with it. Most people won't.

Why not? The first reason is that some of the stocks the strategy returns are ugly and easily dismissed. For example, when I screen for the top 50 $5 billion or larger companies that meet the criteria, there are a good number of potentially scary stocks mixed in with the seemingly safe stocks. Apollo Group (Nasdaq: APOL  ) , Seagate Technology (Nasdaq: STX  ) , and Garmin (Nasdaq: GRMN  ) all make the current list. They face regulatory headwinds in the for-profit education space, the specter of technological obsolescence in the hard-disk-drive market, and smartphones making separate GPS units redundant, respectively.

Now, Greenblatt anticipated this worry and attests that this "Magic Formula" will still work if you pick and choose 20-30 stocks among the top stocks. I'll highlight some of my favorites later.

The second reason is that his strategy won't work consistently. There will be stretches of weeks and months and even years where it gets beaten by the market. This was apparent even in the backtesting that showed the Magic Formula of picking high earnings yield/high returns on capital stocks demolished the market over the last couple decades.

But Greenblatt actually thinks this is a good thing. I agree. The volatility weeds out the temporary practitioners and leaves the true believers. If everyone used the strategy and stuck with it, we'd have to find some other way to beat the market.

What to take away
Before I get to four stocks I personally own that currently meet the Magic Formula criteria, I hope you take away three lessons:

  • Focusing on quality companies (via return on capital) that are relatively cheap (via earnings yield) will help you beat the market.
  • Disciplined simplicity can beat the market.
  • The Little Book That Beats the Market lives up to its name.

Now on to those four companies:

Company

Earnings Yield

Return on Capital

Accenture (NYSE: ACN  )

5.6%

56.6%

Altria (NYSE: MO  )

7.4%

24.2%

Philip Morris International (NYSE: PM  )

6.6%

30.7%

Cisco (Nasdaq: CSCO  )

6.5%

10.7%

Sources: Magicformulainvesting.com and Capital IQ, a division of Standard & Poor's.

Cisco's been a recent purchase for me after last quarter's poor earnings announcement tanked shares. I thought it was a quality company selling at a cheap price, and its presence on Greenblatt's list supports that view. And that's not factoring in the fact that Cisco has 20% of its market cap in cash and will soon join the other three in paying a dividend.    

I've owned each of the other three for quite a while and respect the operations of each. Accenture's asset-light consulting model creates a tremendous amount of value for each dollar of capital used. Meanwhile, tobacco giants Altria and Philip Morris International have operations steady enough to safely pay out the great majority of their earnings as dividends (6.2% and 4.5% dividend yields, respectively).

I also bought shares of Altria for The Motley Fool's own account near today's prices. To view my entire buy thesis write-up as well as the analyses for four other stocks The Motley Fool has put its own money behind, I invite you to take a free report. Click here to download it now.

And remember, there's nothing wrong with beating the market simply.

Anand Chokkavelu owns shares of Accenture, Altria, Philip Morris, and Cisco. The Magic Formula site is among his bookmarks. Accenture is a Motley Fool Inside Value choice. Philip Morris International is a Motley Fool Global Gains pick. The Fool owns shares of Altria Group and Philip Morris International. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (85)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 13, 2011, at 3:36 PM, TheDumbMoney wrote:

    As I already own three of the four stocks you mention, I concur in my own insignificant way. However, as far as short term outperformance, I do not find MO's PEG Ratio of 1.5 to be an optimistic indicator, particularly since I think MO's near-term earnings growth can be reasonably estimated. I can't speak to Accenture, but of the other three I think it's the most likely to underperform for the next year or so at least. I fear MO has benefitted from the thirst for yield, and may suffer more (as it has in the past month or two) as and if economic worries decrease and interest rate expectations increase. Of course, I've owned it for more than a decade and will probably own it for another decade. It's just that underperformance in the next two years or so would not shock me at all. In the meantime I will likely eat red in CAPS. PM also has a nice potential catalyst, should China ever decide to operate within, oh, I don't know, the same multiverse that its WTO obligations exist in, which it could do in part by allowing Marlboros to be sold in China. Of course, I don't expect any U.S. Administration to start lobbying on behalf of PM anytime soon, and I'm sure the Chinese don't either.

  • Report this Comment On January 13, 2011, at 4:30 PM, Fundament wrote:

    The earnings yield is the inverse product of the P/E ratio. The higher the earnings yield is, the cheaper the company seems. The second figure ROCE is defined as EBIT/Capital Employed, a measure for capital efficiency with low barriers.

    Don't you wonder why two tobacco stocks are on your list? I tell you why: They are pretty cheap! But why don't you discover telecom service stocks, they are pretty cheap too? I tell you why: They have lower capital productivity. They need much more money to keep operating business alive.

    These are no buy criteria’s for me. Growth perspectives and market strength are more imported for investors. I have discovered some stock with high margins (operating margin of more than 40 percent), a sign for pricing power. Here are my results:

    http://long-term-investments.blogspot.com/2010/11/11-high-ma...

    All stocks you have picked are good for long-term investors. I like MO and PM due to the high dividend yield and pricing power but MO has no ambitious to grow abroad. CSCO and ACN are perfect picks for the technology sector and good positioned for an international expansion. Long ACN, PM and CSCO!

  • Report this Comment On January 13, 2011, at 4:36 PM, GrumpyOldGuy wrote:

    I tried this method using CAPS. It failed miserably. Epic, Biblical, Apocolyptic failure.

    I then took a free trial of a web service that did it's best to eliminate the "bad" picks that are generated using this method.

    It got rid of Epic failure.

    It got rid of Biblical failure.

    It got rid of Apocolyptical failure.

    It (kind of) got rid of failure.

    But it still underperformed the SPY.

    It's possible I did something wrong. It's possible the system was just in a bad spot and would have turned around and made me rich.

    But I don't think so.

  • Report this Comment On January 13, 2011, at 7:52 PM, GrumpyOldGuy wrote:

    Truthisntstupid,

    Unless I'm wrong this is an updated fersion of "The Magic Formula" by Joel Greenblatt. It has been out for several years and I did try it for about 6 months in CAPS. It destroyed my CAPS rating with some of the absolutely worst picks ever.

    Like I said, I may have been doing it wrong or my timing might have been awful, but it doesn't matter. The draw down in any account that reacted like my trial did would be catastrophic.

  • Report this Comment On January 13, 2011, at 10:25 PM, markbrusatti wrote:

    honelsy guys, how can anyone use 2 metrics and make a decision and while i agree with much that was thats said it this article check this out

    " Meanwhile, tobacco giants Altria and Philip Morris International have operations steady enough to safely pay out the great majority of their earnings as dividends (6.2% and 4.5% dividend yields, respectively)."

    la pregunta es, is the Fool now advocating stocks paying out a great majority of their earnings as dividends? and if so, what constitutes a "great majority"

    and are we talking about REITS here or genuine business enterprises?

    last but not least, as a potential sin investor, i like PM over MO

    ini my opinion, even though im a Bears fan, take the points!

  • Report this Comment On January 13, 2011, at 10:35 PM, dollarpuppy wrote:

    *ahem* magicdiligence.

    Though I haven't personally tried this as an investing style, I have read the book and it won me over. And the absolute best part is the way it weeds out the weak-willed by performing unpredictably over the short-to-medium-term (based on the backtesting outlined in the book. Brilliant.

  • Report this Comment On January 13, 2011, at 10:37 PM, Merton123 wrote:

    Low P/E ratios and high return of capital ratios sounds like Benjamin Graham investing to me. The growth crowd beats the value crowd until the bubble bursts which seems to occur every ten years cycle. Then the value crowd comes out smelling like roses. However, it remains difficult to be a value investor when everyone else is raking in the money during those growth years.

  • Report this Comment On January 14, 2011, at 10:42 AM, SocialRespInvest wrote:

    Part of the reason there is a lot of suffering in the world is because people will buy shares in a company with a business model of addicting and killing people just because it fits a neat get rich formula.

  • Report this Comment On January 14, 2011, at 11:04 AM, pscholte wrote:

    @SocialRespInvest

    Hear Hear!

    What's that I hear in the background? Yes, it is the "Polyanna Chorus." I can live with that. At least I'm not killing people for "filthy lucre," and I still have a tidy little nest egg to boot.

  • Report this Comment On January 14, 2011, at 11:41 AM, TheDumbMoney wrote:

    @Social. My father-in-law died a week ago from complications of COPD, even though he quit smoking eight years ago when diagnosed. My dad smokes disgusting cigars made by Altria. I view my long-term investments in MO and PM as entirely unrelated to the idiotic choices of my father and my father-in-law, and in fact, as just about the only way I directly recoup some of the money they have wasted on cigarettes and cigars and lost productivity in their lives.

    I view socially-responsible investing as a wonderful way to get companies to be more environmentally sensitive (it has worked wonders with WMT, and generally on the whole consumer retail industry), or to pressure them into better labor practices in developing countries (notably, it has worked with Nike). But in the context of opposing an entire industry that the government has chosen to make completely legal, has highly-regulated, and as to which the health risks are excruciatingly obvious and at this point totally well-known, I just don't get it. I find it particularly amusing that many socially-responsible investors who hate tobacco stocks are also among those who support legalizing marijuana, the smoke of which is loaded with carcinogens and is also addictive, and the health risks of which are denied by many of the same people who pillory tobacco companies for having denied the health risks of tobacco in decades past.

  • Report this Comment On January 14, 2011, at 12:39 PM, alldaycricket wrote:

    I never realized what I was doing all along was someone's 'technique', but basically this article describes how I invest and have made about 35% for 2010. It doesn't always work, as the author stated. My personal peice of evidence for this is my purchase of BAC in spring of 2010 at $18. BAC at the time fit the formula, but obviously I didn't make money when I sold at $16. I used to do all the spreadsheets, etc. But then I noticed my lazy picks were beating my scrutinized picks and I noticed my lazy picks all hand in common that they were companies actually making money at the time on their capital and running their businesses efficiently. When stated as such, it becomes a "duh" proposition, because it's so obvious.

    I liked dumberthanafool's comments about tobacco. Tobacco is just voluntary population control. It's actually cheaper for us as a society to have smokers remove themselves from the population earlier and with hopefully a rapidly spreading illness that is covered by their personal insurance and not public benefits. It is really easy to not die of tabacco related illness. I find a way to do it every day by not smoking. It's one of the easiest ways NOT to die, by simply not smoking the product. If someone chooses that, how am I unethical to invest in tobacco stocks?

    Population control, which remarkable no public figure is talking about right now, is probably the most socially responsible discussion we can have. Since we don't talk about it, we'll just have to let MO do the work for us.

  • Report this Comment On January 14, 2011, at 12:49 PM, ringoes wrote:

    So....

    where's ROC in the Fools Stock Screener?

  • Report this Comment On January 14, 2011, at 6:27 PM, ddepperman wrote:

    BlahBlahBlah

    Greenblatt hedges his bets. He shows graphs where stocks picked with his metrics grow amazingly faster than the S&P.

    Later he hedges saying, magic formula not work well every year, sahib, so stick with it and you see you see riches bigmoney come in soona o lateh.

    Investing isn't a fool's game.

    You analyze and think and do it again, and again.

    Greenblatt has been a great help in focusing my thinking.

    A few years back there wuz da guy at fool.com with a book: It's Earnings That Count. I followed it for too long. He even had a program to identify the big earners. Beware the great software program in the sky.

    Like guys, even at fool there are picks that seem to rely on divine intervention rather than metrics. Amazon for instance: P/E 75 (!!!!) P/B 13(!!!!)

    PEG 2.74, ROA 9.59.

    And this company just keeps growing.

    I love ambiguity,

    NFLX same kinda aminal, butr at least the ROA is around 20.

    Greenblatt sez you kin use ROA instead of his fancy metric as a good shorthand, just make sure the ROA >= 25.

    Their 'moats' are perhaps largely in the drive of the companies to be numero uno in their bizniz.

    Don't be victims, don't worry, be happy.

    Don't be whiners(Phil Gramm warned us about that in the last election)

  • Report this Comment On January 17, 2011, at 2:40 PM, porres wrote:

    I tried "Magic Formula Investing" for about three years and did it as they recommended. Bought about 20 stocks from their list, kept them for a year and then sold and bought from the new current list.

    The first two years I averaged 18-20% returns.

    Then I experienced stocks not only going way down but going to zero ( out of business) . How can this be with value stocks with supposedly great ratios?

    They lost me .

  • Report this Comment On January 21, 2011, at 1:04 PM, TMFBomb wrote:

    @porres,

    Sometimes stocks are priced at "value" prices for very good reasons. Greenblatt's theory is that in a basket of these types of stocks, the good stocks will make up for the bad ones...but that doesn't mean every year will be a winner (as you saw).

    Take it for what it's worth...one man's theory for beating the stock market.

    I happen to agree with him and like the "Magic Formula" as a method to find cheap stocks to look into further.

    -Anand

  • Report this Comment On January 21, 2011, at 11:08 PM, larrup wrote:

    Social Issues are not the place to plan your investments, As far as dying goes we are all going to do that. I used to smoke and enjoyed it a lot quit it for health reasons.

    This a legal product and people make a choice to use it so why is it necessary for some people to want to tell others what to do!!

  • Report this Comment On January 23, 2011, at 8:21 AM, shrubthewarcrmnl wrote:

    Beware: The above two "comments" are just links to a commercial web site. My browser checker also shows potential virus and harmful cookies.

  • Report this Comment On January 23, 2011, at 3:04 PM, tomd728 wrote:

    How can anyone recommend CSCO under the

    title "These Stocks Will Beat The Market" ?

    CSCO never has in it's long history of innovation and execution.Sure it brushed off of $30 some time ago but if you owned CSCO 10 years ago @ $20 and held on you would have a $20 CSCO today ! And no dividend to compound to boot.

    An awful stock..................

    http://www.google.com/finance?q=NASDAQ%3ACSCO

    Best,

    Tom

    P.S. If you do buy into this "gem" I sincerely hope

    you do make some money.

  • Report this Comment On January 26, 2011, at 4:34 PM, lucastoa wrote:

    I honestly invest in solid stocks where I do all my detailed due diligence, I found an intelligent approach to investments on the website www.telecomstockguru.com but they now suggest to buy chinese companies, how can I do that from US

  • Report this Comment On September 17, 2011, at 1:45 AM, eesirrius wrote:

    If anybody is interested I just created a site where i will show the results of my magic formula investing portfolio. You can follow the summary that I compile each month. I also display The stocks that go in and out of the magic formula list each weel.

    Have a look at: www.eemagicformula.com

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