5 Magical Stocks

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 had in their hands insights into investing strategies that a value investing master himself used and that were 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

Bare Escentuals (Nasdaq: BARE  )

33%

>100%

$3.69

***

BP Prudhoe Bay Royalty Trust (NYSE: BPT  )

22%

>100%

$54.38

****

DivX (Nasdaq: DIVX  )

40%

>100%

$4.90

*

PDL Biopharma (Nasdaq: PDLI  )

21%

>100%

$6.31

****

RealNetworks (Nasdaq: RNWK  )

21%

>100%

$2.19

**

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
Investing in PDL Biopharma has often been about the stream of royalties it enjoys from the myriad antibody drugs it licensed. It receives payments, for example, on Avastin, Herceptin, and Lucentis from Genentech (NYSE: DNA  ) , and from Elan (NYSE: ELN  ) it receives royalties for Tysabri. More recently, the profit potential has been increased by the spinoff of its biotech unit, Facet Biotech, which has seven humanized antibody products.

The latest quarterly results showed that higher sales of the cancer treatments Avastin and Herceptin pushed royalties higher from Genentech, allowing it to post net income of $40.6 million, or $0.26 a share, compared with a loss of $15.6 million, or $0.09, a year ago. It earned $0.34 a share from continuing operations on revenues that were 75% higher at $68.7 million, better than the $0.09 a share that analysts were expecting on $65 million in revenues.

Perhaps the one disappointment, if it can be called that, is that PDL is expecting to receive only as much as $325 million in revenues this year from Facet, while analysts were anticipating almost $346 million.

Back in December, just prior to the spinoff of Facet, PDL Biopharma saw its shares plummet on the news that the stock would be removed from the S&P MidCap 400 index because it would no longer be "representative" of the mid-cap sector. Mutual funds and institutional holdings are often required to sell a stock that's removed in an effort to rebalance their portfolios.

While some All-Star CAPS members thought there was little to recommend in PDL, in response to one of the negative sentiments expressed, typeiisupernova felt that the royalty stream retained by the biopharmaceutical made it an excellent candidate to purchase:

I just want to help you understand this company. PDLI just spun off Facet biotech to shareholders. Facet will retain the ongoing biotech research/development and products in clinical trials. They will have over $400 million to fund operations for the next 3 years or so. Biotech is boom or bust with individual products, as you know. The royalty stream will be retained under the ticker PDLI. This should be close to $300million/year initially. The Queen patents expire in 5 or 6 years, so whatever royalties this company can collect over that time period should mostly go to shareholders either as dividends or by the company selling the royalty stream to an aquirer. These royalties should grow over this time period as the products that use PDLI patented technology grow or increase in worldwide sales. Costs for the company are minimal; no R&D or product expenses/mostly bare bones administrative with minimal amount of employees. This royalty stream should be worth several dollars a share per year and increase some until patent expiration.

Famed Wall Street investor Seth Klarman, through his Baupost Group, has upped an already hefty stake in PDL Biopharma to more than 14.3 million shares from the 13.8 million he owned back in November. Also notable is his increase in holdings of Facet Biotech as well.

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.

Bare Escentuals and Elan are Motley Fool Rule Breakers selections. Try any of our Foolish newsletters today, free for 30 days

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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