5 Magical Stocks

When fund manager Joel Greenblatt published his guide, 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 easily replicated. As proof, Greenblatt has achieved phenomenal results over the past two decades, even beating 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 could augment Greenblatt's methodology? Below, we've used a "magic formula"-like screen that approximates the criteria for pre-tax earnings and return on capital that 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: Capital IQ (a division of Standard & Poor's) and Motley Fool CAPS. Pre-tax earnings yield is inverse of enterprise value/EBIT. Pre-tax ROC is earnings before interest and taxes divided by tangible capital employed.

Although Greenblatt's strategy is a mechanical one, we don't think you should rely on 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 safer bet from China?
While trying to muscle its way onto the world economic stage, China has exported lead-based kids' toys, toothpaste containing antifreeze, and dog food with melamine in it. So far, the Chinese auto industry has avoided tragic mistakes like those, and while we wait to see what happens to General Motors (NYSE:GM) and Chrysler, maybe China's next plot is world domination through car sales.

That would be good news for diesel engine manufacturer China Yuchai International. While auto sales are expected to fall 8% worldwide for 2009, the plucky little Chinese auto market expects to actually grow 10%. Heck, even GM is able to sell cars there, with sales up 17% in the first quarter. That might enable China Yuchai to become the next Cummins (NYSE:CMI), no?

Well, it's tough to tell because China Yuchai's ownership is as byzantine as the Chinese regulatory process. Although the engine maker is actually three-quarters owned by a holding company based in Bermuda, a 21% stake is owned by Hong Leong -- the largest private equity firm in Asia. That gives it a "golden share" of Yuchai stock that pretty much allows it to elect a majority of the company's directors as well as veto any decision shareholders may vote for. The city government of Yulin, where China Yuchai is located, is also a shareholder.

Such interlocking ownership arrangements have made for some fairly interesting outcomes. For example, as of January, China Yuchai is now the proud owner of a hotel.

Given the predictions for auto industry growth, it's easy to understand why investors might be attracted to China Yuchai anyway. As CAPS member jonconnery suggests, the company could end up supplanting Cummins or even Caterpillar (NYSE:CAT).

China is predicted to have the only major growth economy in 2009. This replacement for Cummins or [Caterpillar] is moving toward leadership in Diesel Engines […] and like so many other products, China will cannibalize western dominance in this vital constructions and farming equipment field ... What's not to like here ???

I'd point to the convoluted ownership and the dominance the private equity interests have in the company. There may indeed be growth opportunities in China Yuchai and profits for investors, but there are risks aplenty, too.

Beat the Street
While he has 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. 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.