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Stockpickr: Signs of Life in Post-Selloff Rubble

James Altucher

The key here is to find quality stocks trading at cheap prices and to stay focused on the primary advantage a retail investor has over an institutional investor: Your performance doesn't have to be positive every day or every month.

Let's take a look at superinvestor Joel Greenblatt, the pioneer behind Gotham Capital, two excellent value investing books, and the Magic Formula methodology.

Founded in 1985 with $7 million, Gotham Capital compounded at 50% per year for its first 10 years since inception, before fees but after expenses. After 1995, Gotham returned capital to all those who were not limited partners, and, as such, the returns were harder to come by. Gotham Capital's holdings can be found on Stockpickr. (Greenblatt's sister Linda has a several-hundred-million-dollar retail-focused hedge fund that we keep track of as well. Despite having $170 million to invest, she owns just two stocks.)

Greenblatt's books, You Can Be a Stock Market Genius and The Little Book That Beats the Markets, are well known among value investors as helpful books with cheesy titles. You Can Be a Stock Market Genius is the more complicated of the two, focused on special investing situations, such as purchasing spinoffs and studying reorganizations.

The Little Book That Beats the Markets is a book Greenblatt wrote for his kids to learn investing; it is much easier to read and follow than his first book. The Little Book That Beats the Markets advocates an approach known as Magic Formula investing, which is essentially a quantitative stock-picking approach that attempts to find high-quality companies trading at a discount.

According to Greenblatt's book, the Magic Formula has returned 20%-plus per year fairly consistently. There are several portfolios on Stockpickr that track various aspects of the magic formula.

In this article, I want to focus on the Dogs of the Magic Formula: the 10 stocks that have been crushed over the past year that now meet the other criteria, which are described below. Additionally, Stockpickr also tracks 20 Magic Formula stocks.

The Magic Formula has two inputs -- pretax earnings yield and ROIC (return on invested capital). The pretax earnings yield is found by dividing EBIT, or earnings before interest and taxes, by EV, or enterprise value, and is used as a measure of valuation.

Theoretically, all things being equal, a company with a 10% earnings yield is cheaper -- that is, a better investment -- than a company with a 5% earnings yield.

ROIC, on the other hand, is used to judge a company's quality and management's ability to allocate capital. A company with a 10% ROIC would earn 10 cents on every dollar it invests in the business. Therefore, a company with a 15% ROIC has wiser management and is of higher quality than a company with an ROIC of only 5%, all things being equal.

Let's examine three of the companies that make up the Dogs of the Magic Formula portfolio.

OmniVision Technologies(OVTI Quote) makes the chips found in many camera phones. Worries about an inventory glut have pushed shares lower over the past year. However, that said, the company has a 23% pretax earnings yield and an 80% return on invested capital. The balance sheet is pristine with $355 million in cash and no debt.

OmniVision has also appeared on a few recent lists, including Forbes' list of stocks that are down but not out, as well as in the portfolio of Volatile Asset Management.

True Religion Apparel(TRLG Quote), which makes high-quality jeans, has been hit hard lately on an earnings shortfall.

True Religion has a forward price-to-earnings ratio of just 13 and a 100% return on invested capital. Additionally, it has $35 million in cash and no debt. The stage is also set for a short squeeze, with more than 44% of the outstanding shares sold short.

Top-performing mutual fund Bridgeway Micro-Cap owns shares of True Religion, and the stock also made the list of Brean Murray's Top Picks for 2007.

Gaming company Cryptologic(CRYP Quote) has been hit hard by recent U.S. legislation that puts a complete clamp on all online gambling. Canada-based Cryptologic sells the software used by many offshore gaming sites.

Although the company's revenue and earnings have been severely hit by the new laws, it's worth noting that it has been diversifying away from onshore revenue for the past five years. For instance, it just sold a license for its online poker software to an offshore gambling site owned by Playboy.

With a $323 million market cap and $126 million in cash, Cryptologic has an enterprise value of $196 million. It is expected to earn $1.18 a share next year, giving it a forward P/E of 20.

Super-deep-value investor Mohnish Pabrai recently disclosed in a Securities and Exchange filing that he owns shares of Cryptologic. Pabrai is a very Buffett-esque investor; I profiled and interviewed him for my book Trade Like Warren Buffett. Mohnish also owns shares of Berkshire Hathaway(BRKA Quote), Universal Stainless(USAP Quote) and several other names.

Additionally, the Cheetah Capital Value Fund holds Cryptologic in its portfolio. Its comment on Cryptologic is that the company "is perceived incorrectly as a high-risk, volatile stock, although it is very profitable, still growing rapidly and, most importantly, is selling at huge discount to intrinsic value." Cheetah also owns shares of KongZhong(KONG Quote); crushed lender New Century Financial(NEW Quote); and the "Canadian Buffett," Fairfax Financial(FFH Quote).

Check out Stockpickr's full list of the Dogs of the Magic Formula. Additionally, we have two other portfolios that keep track of various aspects of the Magic Formula system, including the top dividend yielding stocks among the Magic Formula winners and the top 20 Magic Formula stocks.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Cryptologic, KongZhong and True Religion Apparel to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.