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 which are also easily replicated. 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 (5 max)
General Dynamics (NYSE: GD  )	22%	>100%	$36.31	****
Microsoft (Nasdaq: MSFT  )	20%	>100%	$15.15	***
Perfect World	30%	>100%	$10.44	***
Pfizer (NYSE: PFE  )	21%	>100%	$12.63	****
QLogic (Nasdaq: QLGC  )	22%	>100%	$9.34	*****

Source: CapitalIQ, a division of Standard & Poor's; Motley Fool CAPS. Pre-tax earnings yield is the inverse of EV/EBIT. Pre-tax ROC is EBIT divided by tangible capital employed.
EV = enterprise value; EBIT = earnings before interest and taxes; ROC = return on capital.

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
As much as Microsoft CEO Steve Ballmer has rebuffed any idea of the software giant buying Yahoo! (Nasdaq: YHOO  ) outright, he continues to pine away for a union with the Internet pioneer's search engine capabilities. With its own search engine revamp coming along, being able to tie up that loose end would be a valuable addition for the wizards in Redmond in what is still a crowded field.

Microsoft, of course, is a distant third to Google (Nasdaq: GOOG  ) and Yahoo! in search. Sneak previews of the Live makeover -- code-named Kumo -- is meeting mixed reviews. It's a nice change from Live's results page, but not so radical that we haven't seen Google do it before. That isn't the only change Mr. Softy is revealing.

The new operating system, Windows 7, will be going live sometime this year, with additions designed to keep meddlesome European regulators at bay. For example, users will be able to turn off the Internet Explorer 8 Web browser, as well as the media player and hard-drive search programs.

As criticized as the Vista OS has been, there are those who view the new installment as hardly worth the effort, at least in part because the changes supposedly offer up new security vulnerabilities to hackers. Yet even with alleged flaws there's optimism among analysts that the new model is a cause for Microsoft hope. They estimate that as many as 2% of potential PC owners may upgrade to the latest OS version providing incremental increases in revenues of more than $1.6 billion in the first year alone.

Windows 7 might just be an antidote for what ails Microsoft in its battle against Apple (Nasdaq: AAPL  ) as well. The Mac has not been immune from the recession. Although it has seemingly fared better than the PC, the latest iterations Apple released come at a lower price. Perhaps that's in recognition that it's going to be a difficult year for the computer market. The analysts at Gartner estimate the computer industry will see a 19% decline in shipments this year. That means Apple can't cede any ground to Microsoft, and a buzz about a viable, new operating system might cut into Mac sales.

CAPS member jaybrd2009 actually foresees that happening, with the new product offerings as evidence of a rejuvenated Microsoft:

Low P/E, and a great company relative to its industry at the current moment. Microsoft is a "best of breed" in its industry regardless of direct competition. Programmers love Windows and Graphic designers love Macs. It will take a large effort on Apple's side to target the programmers and network administrators. Windows 7 will be out soon which is a good competition to Apple's operating system, but Windows can be applied to any cheap PC and Apple requires an expensive MAC to operate. In this current economy, not many can afford MAC's for college or school.

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. 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.