When sorting through the thousands of companies available for investment and listed on the U.S. exchanges, I use one pretty basic screen -- high return on invested capital, low price/normalized earnings, and high sales growth. That's one of the methods (in conjunction with qualitative research) I used to identify the stock I recommended for Stocks 2006, the top stock picks for the coming year from 12 Fools (myself included). That screen also led me to some strong competitors for my final choice, including now red-hot Thor Industries (NYSE: THO) and Polaris (NYSE: PII).
It's also more or less the method Joel Greenblatt identifies in his recent best-selling publication, The Little Book That Beats the Market. Greenblatt's mechanical screen has identified stocks that achieved double the market's returns. His screening method doesn't include my sales growth component, but it does examine return on capital and earnings yield. So I wasn't surprised to find my Stocks 2006 pick, as well as a couple of my finalists (including Thor and Polaris), high up on his list of "magical" stocks right now.
A simple screen: good and cheap
Our two methods aren't rocket-science. Plenty of investors see high return on capital as the most important single number to know about a potential investment. Greenblatt identifies it as his one-step screen for good stocks.
The only other step in his "magic formula" is finding stocks that are not only good, but also cheap. To do this, he uses the identical sister of low price-to-earnings ratio (P/E) -- high earnings yield.
His magic formula combines these two factors with a special algorithm, searches all the stocks in the market at the end of every day, and voila! -- you've got a list of potentially superior investments. You can check out all of the stocks that come up on his screen in chunks of top 25, top 50, or top 100, and by market cap, and that's all kind of fun. Right now, if you ran the screen for companies with market caps greater than $1 billion, CBS (NYSE: CBS), Boston Scientific (NYSE: BSX), Medicis Pharmaceutical (NYSE: MRX), Lexmark (NYSE: LXK), UST (NYSE: UST), and 20 others would top the list. Some recent volatility with the price has been knocking my Stocks 2006 pick in and out of the top 25, but today it's back on the list.
Combining two "best of" lists
While there has been widespread praise for Greenblatt's book and companion website, some have poked holes in his magic formula for not including qualitative factors. After all, reported earnings can be highly misleading, return on capital figures can be distorted by off-balance sheet items, and sometimes a low trailing P/E or high earnings yield are the products of nonrepeatable factors or market cycles. Having some sort of qualitative study would lead you to be skeptical of some of the companies on the list. It also might lead you not to invest in adult entertainment provider New Frontier Media, which comes up on the top 25 with market caps over $50 million.
But when the raw data places a company in Greenblatt's list, and it's confirmed by some qualitative analysis, you just might have something. I did recently, when I saw that fellow Fool Seth Jayson's Stocks 2006 pick was also on the Greenblatt list. After a minor pull-back in that stock, I acquired a few shares, and a couple of weeks later, that investment is up 22%. So I'm happy about that, and I suppose I owe Seth a beer.
I don't know the individual methods the other authors of our Stocks 2006 used to identify their picks, but interestingly, two additional picks besides Seth's and mine are also on the Greenblatt list.
So I think that you'll do pretty well reading Greenblatt's book and using his free formula to identify likely market-beating stocks. Combine that list with some qualitative analysis like you'll find in Stocks 2006, and I think you'll do even better.
Click here to get your copy of the Fool's Stocks 2006 special report.
Bill Barker owns shares in the stock he recommended for
Stocks 2006
, as well as, happily, shares in the stock Seth Jayson recommended. He does not own shares in any other companies and, in particular, not in any adult entertainment stocks -- not that there's anything wrong with that. The Fool has a disclosure policy.
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