2 Magic Formula Pick's With Headline Risk

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors like a good deal. The problem is, most of us wouldn't know a bargain if it hit us in the face.

At least that's what hedge fund manager and value investing icon Joel Greenblatt says. In a series of books and lectures, Greenblatt has touted his "magic formula" for stock picking. Greenblatt argues that by following the simple formula we can take the guesswork out of picking bargain stocks.

So what is the magic formula?

I'm glad you asked. Simply put, it's the best-ranked stocks with low earnings yields and high returns on capital. By using these two rankings, the formula seeks to find cheap stocks with underlying businesses that are performing well. And while that sounds overly simple, following this formula would've helped you trounce the market over many years.

I've looked through the best ranked stocks according to Greenblatt's formula, and these three stocks are amongst the most compelling today.

Bad news, good gains

The essence of the "magic formula" is finding great businesses at steep discounts to their intrinsic value. If a company truly is a value pick, and is trading at a discount, negative headlines are almost always the cause. Has there been a worse series of headlines surrounding any business than the health insurance companies?

So while Humana (NYSE: HUM) has a current earnings yield of 9.87%, and Wellpoint's (NYSE: WLP) earnings yield is only 8.78%--cheap valuations are nothing new for these stocks.

Betting against these stocks has been dead wrong, as both have nearly doubled this year alone. Yet at the same time the stocks are still trading at dirt cheap prices; will tomorrow really be the day that the skeptics are proved right?

Rounding out our magic formula criteria, Humana comes in with return on capital of 7.13%, and Wellpoint has a return on capital of 10.42%. Both stocks obviously look cheap and have performed well. Nobody knows what impact healthcare reform will actually have on these companies. On the plus side there will be millions of new (previously uninsured) customers coming into the fold.

Analysts consensus earnings estimates are actually showing growth for both of these firms. My take is, unless healthcare reform decimates these businesses, they'll still turn out to be values at these levels.

Neither of these businesses rank in the top ten of Greenblatt's formula, they simply rank highly. But I feel that value screener's can only point you in the right direction, then it's up to you to pick the best of the best. These firms are seeing record membership levels, and actually (in some cases) increases ot government benefit programs, the low valuations may not be justified.

It's OK to like a value

Everyone likes a value, but finding them doesn't have to be so hard. What I like best about Joel Greenblatt's "magic formula" is that it provides outstanding returns without making the process cumbersome. It cuts straight to the two most important aspects of buying a stock: the stock's value and (business) performance.

That said, while it makes sense to start with the magic formula to screen stocks, but ultimately you'll have to make the call on which stocks to buy.

Healthcare finds itself in a classic case of headline-induced value. The trick for investors will be determining if the risk is just headline risk, or something more.

So far, the headlines have been dead wrong. 

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Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends WellPoint. The Motley Fool owns shares of WellPoint. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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