These 5 Stocks Have a Little Magic

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, beating even 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 companies with top ratings of four or five stars from Motley Fool CAPS.

Over the first 20 months of the collective intelligence database, it was found that newly minted five-star stocks offered the best opportunities for investors, whereas the lowest-rated companies fared the worst. 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; 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 on this as simply a list of companies to buy. Due diligence is always needed. So, let's see what CAPS members have to say about a couple of these.

A little bit of pixie dust
Providing logistical support to the U.S. military has earned KBR a reputation for not only being a successfully competitive bidder, but also a point for controversy. Even so, KBR, along with DynCorp International and Fluor (NYSE:FLR), was awarded a part in the latest contract for logistical support, called LOGCAP IV. Each contract has a maximum value of $5 billion per year, allowing the Army to award a total of $15 billion annually among the companies and a lifetime maximum of $150 billion. That may prove to be a richly rewarding situation.

Despite the controversies, CAPS member DoubleAmerica finds KBR to be a seasoned player that has been unfairly beaten down.

I like KBR as a long term play for a few reasons. First, they are a spinoff from Halliburton, therefore have a proven business model and a history of strong performance. Second, engineering will be in demand forever and they should be able to take advantage of that. Third, at a price around 17 dollars per share, you are able to assure a good margin of safety with the stock trading at a little over book value and with almost $7 in cash per share. So since they have been beaten down unfairly with their energy-based clients, they present an attractive long term opportunity at these levels.

Stealing opportunities
With the end of the commodities boom, shares of both CF Industries and Terra Industries have fallen. While both companies have been prodigious generators of cash, one has to wonder what impact a combination of the two would have. That may become reality if Terra accepts CF's unsolicited $2.1 billion buyout offer. Analysts look at the combination as a means of boosting both prices and margins because the nitrogen fertilizer market tends to be fragmented on the world stage.

CAPS member rayandfran liked CF Industries even before it made the acquisition offer because of its ability to throw off cash.

This company sports a phenomenal $20.26 / share in cash with nearly no debt ($0.08) which even [PotashCorp] can't stand up to ($9.97). The P/E is a [minuscule] 4.85 and I don't believe the company's 5 year growth rate is 3% (Yahoo!). Take out the cash and the P/E is even more astounding at 3. If there were ever such a thing as a value and growth pick, this would be it!

CAPS All-Star goldminingXpert takes a different tack with Terra Industries, finding it an undervalued arbitrage play because of its stake in Terra Nitrogen (NYSE:TNH).

Dramatically!!!!! undervalued versus [Terra Nitrogen]. Long this short [Terra Nitrogen] as an arbitrage play. [Terra Industries'] stake in [Terra Nitrogen] is worth $300 million more than [Terra Industries'] entire market cap!!! [Terra Industries] is too low or [Terra Nitrogen] too high.

Beat the street
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. 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.