Don't have as much time to research stocks as you'd like? That doesn't mean you have to settle for index fund returns. Value investor and Columbia professor Joel Greenblatt shares his "Magic Formula" for market-beating stock returns in his book The Little Book That Beats the Market.
The Magic Formula ranks stocks based on two factors: how cheap the stock is relative to the company's earnings, and how profitable the company is. Greenblatt suggests buying the top-ranked stocks, holding them a year (give or take a week for tax purposes), and then reinvesting in the latest batch of top stocks.
That may seem too simple. But when Greenblatt backtested his formula on the 3,500 largest U.S. stocks, excluding utilities and financials, he found that the top 30 stocks generated an annualized return of 30.8% from 1988 through 2004, compared with 12.4% for the S&P 500 Index (excluding trading costs and taxes). Moreover, when he ordered those stocks by ranking, then split them into 10 groups of 350 each, he found that the higher a group's ranking, the higher its returns.
A Foolish twist
I decided to boost the Magic Formula with help from The Motley Fool's CAPS community. Greenblatt observed that fundamental research by knowledgeable investors improved upon his approach. Why not use the wisdom reflected in CAPS scores to refine a list of stocks that do well according to the Magic Formula criteria -- and hopefully sidestep some value traps?
To do so, I ran a stock screen looking for stocks on the major U.S. exchanges with high returns on capital of at least 15%, and relatively high operating earnings yields of 7% or more. Like Greenblatt, I filtered out utilities and financials, as well as stocks with market caps less than $500 million, or share prices less than $5. After ranking the results, I then selected only stocks that earned a top five-star rating on CAPS. Here are the seven highest-ranking stocks that passed the screen:
Earnings Yield (EBIT/EV)
Market Cap ($mm)
National Presto Industries
Alliance Resource Partners
Philip Morris International
Source: Capital IQ and The Motley Fool as of June 29, 2011.
Since I last ran the screen, Joy Global and Western Union fell out of the top seven and were replaced by Colgate-Palmolive and Philip Morris.
Patience is a virtue
The Magic Formula is designed for the long haul, and it's not for the faint of heart. In Greenblatt's backtest, it underperformed the market in one of every four one-year periods, and one of every six two-year periods. Over three-year periods, though, it beat the market in 19 of every 20 periods tested (that's 95% of the time).
Stocks that score well under the Magic Formula criteria have the potential to significantly outperform the market, but its mechanical approach sometimes gives value traps high rankings. Using CAPS to refine those results could help you avoid such pitfalls, while building a portfolio of inexpensive stocks in highly profitable companies.
Interested in these high-scoring stocks? Add them to My Watchlist, our free personalized stock tracking service, now:
Fool contributor Cindy Johnson owns shares of TeleNav. The Motley Fool owns shares of Philip Morris International and National Presto Industries. Motley Fool newsletter services have recommended buying shares of Western Union, Alliance Resource Partners LP, Partner Communications, and Philip Morris International. Motley Fool newsletter services have recommended creating a write covered strangle position in Western Union. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.