5 Magical Stocks

The 2005 publication of fund manager Joel Greenblatt's The Little Book That Beats the Market gave investors a unique opportunity. They could now follow the easily replicated strategies of a value investing master. Using the formula outlined in his book, Greenblatt has achieved phenomenal results over the past two decades, besting even the performance of Warren Buffett.

His 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 pre-tax earnings and return on capital criteria he lays out, then adds the ratings from our Motley Fool CAPS investor-intelligence database. Combining those rankings with Greenblatt's suggested criteria should give us winning investments with the potential for 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; Motley Fool CAPS. Pre-tax earnings yield is inverse of EV/EBIT. Pre-tax ROC is EBIT divided by tangible capital employed.

Although Greenblatt's strategy is a mechanical one, we don't think you should rely upon this as simply a list of companies to buy. Due diligence on this narrowly focused list of companies is always a Foolish thing to do. So let's see what CAPS members have to say about one of these magical companies.

A little bit of pixie dust
Russian mining and metals company Mechel was sent to the equivalent of Siberia after Vladimir Putin put the company in his crosshairs last July, attacking its pricing policies and saying it should be investigated for tax evasion. The stock, which had been trading as high as $58 a share, sank to less than $3. The latest earnings report would hardly seem to take that chill out of the air.

Coking coal production plunged 76% in the first quarter, compared to a year ago, while steam coal output fell 19% in the same period. Steel production wasn't any better, down just shy of 30%, and rolled products output fell nearly 22% year over year.

Putin has shown willingness to seize private property for government usage, like Hugo Chavez has in Venezuela. Oil drillers Williams (NYSE:WMB) and Ensco International (NYSE:ESV) are only the latest to face pressure from the Chavez administration.

Growth should remain problematic for Mechel. Although it was able to boost capacity earlier this year -- albeit well below the highs set last year -- Russia's steelmakers were able to gain some market share in China, which got an economic boost from government stimulus spending. But those gains are not expected to stick as contracts come up for renewal and prices get renegotiated.

Despite its valid short-term concerns, the long-term outlook for Mechel seems better, assuming Putin stays away. Mechel combines mining, steel, ferroalloys, and power, which it markets domestically and internationally. Its shares remain depressed, but it might not really get a chance to take off until after the world's economies show more of a good-faith effort at recovery.

Top-rated CAPS All-Star member porcelain808 seems optimistic, despite the risk associated with speculation in Mechel's shares:

Please, Russia, don't turn off the spigot. Or keep it on - depends on how you look at it. If this is a truly functioning, independent company (or whatever the current Russian equivalent might be), then buying in right now to take advantage of the below-book-value vs. potential based on 52-week high is alluring. Should be good for at least some significant short-term upside, right?

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 own buy or sell decisions. Start your own research on these stocks on Motley Fool CAPS, where 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.