5 stocks for a 'magical' portfolio

By The Motley Fool

Hedge fund manager Joel Greenblatt's 2005 book, "The Little Book That Beats the Market," explained to investors how they could produce exemplary long-term value applying a "magic formula" to find companies that are both profitable and cheap.

Greenblatt, the founder of Gotham Capital, has employed his strategy to achieve phenomenal results that even surpassed those of renowned value investor Warren Buffett over the past two decades.

To produce his magic, Greenblatt focuses on just two measures -- earnings yield and return on capital. His investment strategy is simple: Buy undervalued, high-performing companies and hold for a year. Wash, rinse and repeat.

• Today's upgrades and downgrades

But what if we can augment Greenblatt's methodology? We used a magic-formula-inspired stock screen to identify prospective investments, then looked at the results through the prism of the MSN CAPS investor intelligence database. Combining the CAPS ratings and commentary with the criteria Greenblatt recommends should lead us to investments capable of producing outsize returns.

Here are a few of the names that recently emerged when we screened for good companies at bargain prices:

Profitable and cheap?

Company	Sector	Pretax earnings yield	Pretax return on capital	CAPS rating
Dish Network	Pay-TV services	23%	>100%	**
Franklin Resources	Money management	27%	>100%	***
General Dynamics	Aerospace and defense	22%	>100%	****
Herbalife	Diet supplements	33%	>100%	*
Perfect World	Software	24%	>100%	***

We don't think you should rely upon this as simply a list of stocks to buy. Due diligence on this narrowly focused list is always a smart requirement. Meanwhile, let's see what CAPS members have to say about one of the candidates.

Drop and go

You won't confuse the new heavy-duty GD8000 notebook computer from defense contractor General Dynamics (GD, news, msgs) with the MacBook Air. Where Apple's (AAPL, news, msgs) ultrathin laptop weighs in at a featherlike 3 pounds ("featherlike" for a laptop, anyway), the rugged GD8000 tips the scales at almost 8 pounds and comes housed in a magnesium chassis wrapped in a polycarbonate casing. Of course, the MacBook Air wasn't designed to be toted around by military personnel.

Notebook computers are not the first thing that pops to mind when investors think of General Dynamics. The Falls Church, Va., company is better known for its armor-plated military vehicles, Gulfstream business jets and nuclear-powered submarines.

But the Pentagon wanted a notebook computer capable of surviving a 3-foot drop and able to be booted up at least 26 times after the fall. Manufacturers were allowed to use as many as five computers to pass the test, but General Dynamics said the GD8000 passed on the first drop -– from a height of 42 inches. The machine also withstood 30 gallons of water being blasted at it at 40 mph for four hours to simulate a torrential rainstorm.

General Dynamics' information systems and technology segment accounts for nearly one-third of company profits. In addition to providing sophisticated electronics for land-, sea- and air-based weapons systems, the unit also does business with federal civilian agencies and commercial customers.

It's General Dynamics' aerospace division, accounting for about one-quarter of profits, that is causing headaches. Executives are loath to fly corporate jets these days, with an angry public viewing the aircraft as symbols of excess. Consequently, demand for the company's Gulfstream jets is losing altitude.

General Dynamics derives 69% of its revenues from the U.S. government, and that has many investors at the CAPS community feeling secure about its future. CAPS member "KnockoutMouse" argues that national defense cements its place as a winning investment.

"This company makes the armored vehicles that (will) help our troops survive in the guerrilla warfare environments of the future. They make the submarines, destroyers and littoral combat vessels that will be the basis of naval power in the 21st century," KnockoutMouse recently wrote. "America needs this stuff no matter how the economy is doing or who the president is because our basic security depends on it. The stock is trading near a 52-week low and yielding over 4%. In fact, they just boosted their dividend while most other companies are cutting theirs, (so) that should tell you something about their future."

On CAPS, General Dynamics has a four-star rating and commands a bullish following from more than 1,000 members. You can check out what they're saying about the company and offer your own opinions at CAPS, the community organized to help investors evaluate stocks, test investment strategies and gather the collective wisdom of more than 130,000 participants.

Each stock's CAPS page is a good place to start your research; you can find a company's financial reports, scrutinize key data and charts, and examine the comments your fellow investors have made. Turn to member blogs for insight and opinion. And the CAPS stock screener tool lets you find companies that satisfy your investment criteria.

Let your voice be heard. It can make a difference.

This article was reported by Rich Duprey for The MotleyFool. At the time of publication, he owned none of the stocks mentioned.