These 5 Stocks Have a Little Magic

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 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 companies with top ratings of four or five stars from Motley Fool CAPS. 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 (5 stars max)
Double-Take Software (Nasdaq: DBTK  )	22%	>100%	$7.03	*****
Endo Pharmaceuticals (Nasdaq: ENDP  )	24%	>100%	$22.73	*****
Heartland Payment Systems (NYSE: HPY  )	20%	>100%	$8.44	****
King Pharmaceuticals (NYSE: KG  )	38%	>100%	$8.70	****
OpenTV	23%	>100%	$1.12	*****

Source: Capital IQ, 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 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 one of these.

A little bit of pixie dust
As the sixth-largest payment processor in the U.S., Heartland Payment Systems has an envious business model. It's able to generate copious amounts of cash every time a bankcard holder swipes a credit or debit card. Heartland found a niche in focusing on facilitating a transaction between hundreds of thousands of businesses and the banks that issue the cards, typically under the Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) nameplate. It's specialized even further by concentrating mainly on restaurants, where it generates 40% of its volume.

That niche has proven extremely profitable. Where revenues have grown at a compounded rate of more than 30% over the past five years, operating profits have sizzled at a 55% pace, making Heartland one of the fastest-growing payment processors in an industry dominated by First Data and Global Payments (NYSE: GPN  ) .

Yet the transaction processor suffered a blow to its business when it reported a massive breach in security last month that compromised an estimated 100 million account numbers at 157 banks in 40 states, ranking it as perhaps the worst such break-in ever.

While Heartland was able to locate the malware and shut it down, and maintains that more sensitive data like Social Security numbers and PINs were not affected, that doesn't mean investors should rush forth into the, well, breach, as it were.

The situation is still in the early stages of investigation. Visa and MasterCard said that they notified Heartland as early as October of problems, but that the company did not tell the public for several months until, it says, it was able to locate the malware. Even though the stock has lost three-quarters of its value from its 52-week high, there may yet be further revelations to cause a greater deterioration.

It would serve a prudent investor to allow the dust to settle before moving in, even if that means missing the bottom here. Assuming Heartland is able to avoid any further embarrassing details coming to light, its cash-generating business model would suggest that the contrarian nature of investors like All-Star CAPS member TSIF will be rewarded as this becomes a regrettable but momentary distraction. As TSIF wrote last month:

Price after the security breach finally puts this stock at an attractive multiple. In actuality, if you believe the analysts the security breach could put them under. I don't think they are in the same class as CardSystems. Also, I'm a bit of contrarian, so bring it on! The PR team is doing a great job so far. That may not make the consumer any happier, but Heartland is buffered by the banks who issued the cards. Their low debt should help them digest the fallout and their cash on hand should help with any retributions. If the card issuers jump ship all bets are off, but I'm betting they will have a Heart and stick with the company they know.

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. Start your own research on these stocks on Motley Fool CAPS, where your opinion can 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.