Magic Formulas and Market Doubles

There are no magical formulas in investing. We do, however, now have MagicFormulaInvesting.com, and, given the overpromise-and-underdeliver-sounding title, it's more worthwhile than you might think.

This comes as little surprise considering that Joel Greenblatt is the website's originator. Greenblatt seems to specialize in combining quality information with somewhat cheesy titles. (Not entirely unlike The Motley Fool, some might say.) I saw Greenblatt, best known as the author of You Can Be a Stock Market Genius, on CNBC the other day. He was discussing his new book, The Little Book That Beats the Market, and the theory behind it.

I haven't read his new book, but it is explained on his Lucky Charms website . err, make that Magic Formula Investing . which works in tandem with his new book. Greenblatt's backtesting shows that buying stocks that rank highest in a combination of earnings yield (the inverse of the price-to-earnings [P/E] ratio) and return on capital have doubled the market's returns, and his website shows what stocks pass the test right now.

Abracadabra and ...
That such a simple combination could possibly offer market-doubling returns is interesting to me, though it's hardly surprising. We've been advocates of paying close attention to return on invested capital for a long time. In fact, if you use this odd little search engine I found called "Google" and enter return on invested capital, you get nearly 9 million results, and Nos. 3 and 4 come from our website. Those articles are worth reading, particularly if doubling the market's returns is appealing to you and if you've ever wondered if something other than magic explains why such stocks might do so.

Buying low-priced stocks (low P/Es = high earnings yield) that also are the best at making profits on their invested capital is something that has a great deal of intuitive appeal. It's actually a variant of a screen that I often use, though I usually combine those two factors with increases in sales as well. So the stocks that show up on my personal screens largely overlap with the stocks that appear on the "magic formula" site. If you're not entirely a mechanical investor, the site might pique your interest for producing screens, rather than a final answer of what makes for the best stocks. Let's take a look at a few of the highest-ranked stocks at the moment.

Eye of newt and other elixirs
In the larger-cap world (stocks with market caps over $2 billion), of the 25 highest ranked stocks the search engine comes up with, two overlap with selections from our newly released Stocks 2006 publication (including my own), though I won't name them here. (Click here if you want to check it out.) The list also includes traditional return on capital monsters such as Thor Industries (NYSE: THO  ) , UST (NYSE: UST  ) , Quest Diagnostics (NYSE: DGX  ) , and Buffett-favorite H&R Block (NYSE: HRB  ) . Expanding the list to the top 50 shows ExxonMobil (NYSE: XOM  ) and Johnson & Johnson (NYSE: JNJ  ) qualifying. None of these strike me as high-risk plays, and they've all magnificently rewarded investors in the past.

On the other hand, screens like this on smaller-cap stocks will sometimes pull up companies whose earnings numbers might be too good to be true. Among the top 25 businesses on the screen of companies with market caps higher than $500 million, we find Escala Group, which is down more than 20% today on the heels of articles both at this site and The Wall Street Journal questioning the company's operations. It also includes the somewhat larger Career Education (Nasdaq: CECO  ) , which is the subject of multiple investigations from the SEC to the Justice Department to 60 Minutes. In other words, its stock price might be cheap for a good reason. So digging into these stories, rather than buying blindly on the screen's recommendations, will improve your results. Or, at least, it'll make you feel more comfortable with what you own.

This gets more and more important the further down the market capitalization list you go, because the published financials are more likely to be skewed by one-time items or past numbers that just don't look repeatable. All of these lists are laden with oil companies, which obviously have been producing great profits (especially for shareholders) in the very recent past. But those profits are not necessarily expected to grow at nearly the same pace in the short term.

The screen also highlights a number of stocks that are currently recommended by our small-cap Motley Fool Hidden Gems newsletter -- and it's always nice to see one's qualitative work confirmed by quantitative screens. Again, when investing in small caps (which typically offer higher potential rewards) I think you're well advised to dig deeper into the stories of these companies well beyond a blind screen. That's what we do at Hidden Gems, and the selections so far are producing returns of 31%, compared with the market's 12% returns over the same period.

Foolish final thoughts
While we don't claim to have magic on our side in producing these results, we're happy with them nevertheless. You can click here right now to take a free no-risk 30-day trial of the newsletter and you'll enjoy immediate access to today's two new recommendations. There are also more than 50 other selections, if you're interested in seeing how such market-beating results can be produced magic-free.

Bill Barker does not own shares in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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