5 Magical Stocks

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, even besting 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.

Source: CapitalIQ, 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. EV is enterprise value; EBIT is earnings before interest and taxes; ROC is 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
It wasn't exactly a lethal dose that Merck (NYSE:MRK) delivered to drug delivery specialist SurModics when it decided to end their collaboration last year on an eye medication delivery therapy, but the stock has lost about half its value since then.

Revenues in its first quarter surged as a result of that termination, due to it being able to realize more than $34 million in deferred revenues. But even adjusting for that one-time influx, SurModics was able to beat expectations in its first quarter.

That's resulted in the stock becoming more appropriately valued. As one of the few companies in the industry that has been able to make a profit from the fusing of biotechs and pharmaceuticals, it has often traded at a rich premium. But as the Merck deal showed, its reliance on a handful of partners holds risks. Johnson & Johnson (NYSE:JNJ), for example, accounted for 20% of its revenues, while Abbott Labs represented another 10% slug of sales this past fiscal year.

Investors need to be mindful about the potential loss of any of SurModics' remaining big-name partners. Its drug delivery unit derives most of its profits from Johnson & Johnson's Cordis drug-eluting stent business. But the pharmaceutical giant just reported Cordis' U.S. sales were down 28% in the first quarter and were off 16% worldwide as the stent business has become crowded.

Might it eventually give up on the business? It seems a real possibility, particularly since an appeals court upheld claims that J&J's Cypher stents (which are sold by Cordis) infringe on patents held by Boston Scientific.

Of course, with a successful and profitable business model, another option is that SurModics' products could be brought in-house by one of the pharma giants. That's one reason investors might think the biotech could deliver big profits in the future. CAPS member paggles had this to say:

Well positioned for growth in health care sector. Could be bought by major drug company by the end of 2009. Several things to like for the beaten down price

Before diving in, however, investors may want to consider that if J&J's stent business has been having troubles, SurModics' own revenues and profits may be hard hit. With second-quarter earnings to be released in the next few weeks, there may come an opportunity to get the biotech at better price points.

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, where your opinion can still 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.