To paraphrase Albert Einstein, investing should be made as simple as possible, but not simpler.

Good companies at cheap prices
Joel Greenblatt could be called a stock market genius. His firm, Gotham Capital, has reportedly earned 40% annual returns, and he has an Einstein-like knack for simplicity. In The Little Book That Beats the Market, he asserts that investors can earn 30% annual returns by simply selecting a basket of good companies trading at cheap prices. He suggests using return on invested capital to find good companies, and the earnings yield to screen for cheapness. Having found a handful of stocks that meet those criteria, Greenblatt suggests buying and holding them for a year, selling, then rinsing and repeating. Following that strategy, backtesting showed 30% annual returns for 17 years from 1988 through 2004.

As simple as possible ...
How can we find stocks that might qualify under Greenblatt's formula? I used our new CAPS screening tool to find some stocks that Einstein, Greenblatt, and our CAPS community intelligence might find appealing. Here's the screen:

  • A low price-to-earnings ratio.
  • A high return on equity, a viable substitute for return on invested capital.
  • And, as a twist, a five-star rating in Motley Fool CAPS.

What makes that a twist? Well, from November 2006 (when we started tracking) through the end of last June, five-star stocks as a group handily outperformed the market, with an average annual gain of more than 12%, compared to essentially flat returns for the broader market. So even though Greenblatt recommends selling every year, you could probably hold such outperformers even longer and still beat the Street.

Company

P/E

ROE

American Eagle Outfitters (NYSE:AEO)

10.4

24.5%

Ceradyne (NASDAQ:CRDN)

7.0

21.3%

Coventry Health Care (NYSE:CVH)

8.9

16.9%

Noble (NYSE:NE)

8.3

29.4%

PT Telekom Indonesia (NYSE:TLK)

8.9

35.5%

Tata Motors (NYSE:TTM)

8.2

19.8%

Titanium Metals (NYSE:TIE)

9.7

17.3%

Data from Motley Fool CAPS as of Sept. 17, 2008. TTM = trailing 12 months.

... But not simpler
You don't have to be Einstein to understand that these companies are only a starting place for your own due diligence.

Would Einstein approve of these selections? Would Greenblatt have them on his list? Maybe you have some ideas of your own about their merits. Come and join us on Motley Fool CAPS to share your opinion with our 115,000 (and growing) members.

Simple Foolishness:

Tata Motors and PT Telekom Indonesia are Motley Fool Global Gains picks. PT Telekom Indonesia is also a Motley Fool Income Investor recommendation. Coventry Health Care and American Eagle Outfitters are Motley Fool Stock Advisor picks. The Fool owns shares of American Eagle Outfitters. Try any of our Foolish newsletters today, free for 30 days.

Fool analyst and CAPS member Nick Crow didn't own stock in any of the above companies at the time of publication. The Fool has a disclosure policy.