These Stocks Will Beat the Market

Forget get-rich-quick schemes. Even get-rich-slow methodologies can lose you serious money.

That's why most investors are best served by index funds and ETFs.

But for those of us who want to beat the market, there's one very simple stock picking method that can make us serious money. Read on, and I'll tell you about the method and share some resulting stock picks.

Why I think it'll work
We listen to folks like Warren Buffett and Peter Lynch because (1) their track records are amazing, and (2) their advice makes intuitive, common sense.

Buffett has averaged around 20% returns for half a century. Lynch averaged almost 30% returns for more than a decade. The guy whose stock picking method I'm going to tell you about has averaged about 40% during his run!

And his advice is actually more actionable than the general principles espoused by Buffett and Lynch. In fact, he tells you exactly which stocks to pick. I'll reveal some of my favorites later, but first, the methodology.

The stock-picking method
Joel Greenblatt's stock-picking method is heartbreakingly simple for those of us who pore over 10-Ks, follow each minor press release, and build large spreadsheets and financial models to find undervalued stocks.

In his book, The Little Book That Beats the Market, he masterfully explains the basic principles behind his market-thrashing success.

It boils down to just two things. Find stocks with:

1. high earnings yields, and
2. high returns on capital

Think about that for a second. Earnings yield is just how much the company makes versus how much you pay for the stock. And return on capital is just how much the company makes versus how much the company pays for its business.

And it's all just on the last year's performance. No need for analyst growth estimates or dissecting the future viability of the business. In its simplest version, you just rank stocks over a certain size (say $50 million or $5 billion) on these two metrics and pick the top 20 to 30 stocks.

Why you won't follow it
Really? That's it? Basically, yes. I'm leaving out some of the gory details you'll want to read about before executing the strategy, but it's that simple. There's a catch, though. The catch is you probably won't follow it.

You read that right. Even if you buy what I'm writing, read Greenblatt's book, and try it for yourself, you probably won't stick with it. Most people won't.

Why not? The first reason is that some of the stocks the strategy returns are ugly and easily dismissed. For example, when I screen for the top 50 $5 billion or larger companies that meet the criteria, there are a good number of potentially scary stocks mixed in with the seemingly safe stocks. Apollo Group (Nasdaq: APOL), Seagate Technology (Nasdaq: STX), and Garmin (Nasdaq: GRMN) all make the current list. They face regulatory headwinds in the for-profit education space, the specter of technological obsolescence in the hard-disk-drive market, and smartphones making separate GPS units redundant, respectively.

Now, Greenblatt anticipated this worry and attests that this "Magic Formula" will still work if you pick and choose 20-30 stocks among the top stocks. I'll highlight some of my favorites later.

The second reason is that his strategy won't work consistently. There will be stretches of weeks and months and even years where it gets beaten by the market. This was apparent even in the backtesting that showed the Magic Formula of picking high earnings yield/high returns on capital stocks demolished the market over the last couple decades.

But Greenblatt actually thinks this is a good thing. I agree. The volatility weeds out the temporary practitioners and leaves the true believers. If everyone used the strategy and stuck with it, we'd have to find some other way to beat the market.

What to take away
Before I get to four stocks I personally own that currently meet the Magic Formula criteria, I hope you take away three lessons:

• Focusing on quality companies (via return on capital) that are relatively cheap (via earnings yield) will help you beat the market.
• Disciplined simplicity can beat the market.
• The Little Book That Beats the Market lives up to its name.

Now on to those four companies:

Sources: Magicformulainvesting.com and Capital IQ, a division of Standard & Poor's.

Cisco's been a recent purchase for me after last quarter's poor earnings announcement tanked shares. I thought it was a quality company selling at a cheap price, and its presence on Greenblatt's list supports that view. And that's not factoring in the fact that Cisco has 20% of its market cap in cash and will soon join the other three in paying a dividend.    

I've owned each of the other three for quite a while and respect the operations of each. Accenture's asset-light consulting model creates a tremendous amount of value for each dollar of capital used. Meanwhile, tobacco giants Altria and Philip Morris International have operations steady enough to safely pay out the great majority of their earnings as dividends (6.2% and 4.5% dividend yields, respectively).

I also bought shares of Altria for The Motley Fool's own account near today's prices. To view my entire buy thesis write-up as well as the analyses for four other stocks The Motley Fool has put its own money behind, I invite you to take a free report. Click here to download it now.

And remember, there's nothing wrong with beating the market simply.