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For Stock Market Success, Buy C-R-A-P

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( Magic Diligence) -- The safest and most reliable path to stock market success is to invest in CRAP stocks.

The strategy we follow, Joel Greenblatt's Magic Formula® Investing, is a great mechanical, qualitative screen for digging up candidates. But to find the CRAPpiest of stocks, we need to get our hands dirty and dig our noses into the financial statements, conference calls, SEC filings and industry research. Only then can our portfolios come out smelling like roses.

What in the heck am I talking about? Four points of research:

1. Conservatively managed

The best companies are managed conservatively, and are always focused on earning high returns on capital instead of overpaying simply to grow or build an empire. By maintaining reasonable levels of debt and always having a healthy cash balance for the inevitable bumps in the road, these companies are built to last through thick and thin.

Traders

How can you tell if a company is conservatively managed? Firms that have zero or very little debt (like Dolby (DLB), or Activision (ATVI)) are more conservative than Ann Coulter on a Sunday morning. In general, be wary of firms that carry significantly more debt than cash on the balance sheet or whose operating earnings do not cover interest obligations more than five times over. An example of a company managed too aggressively would be FriendFinder (FFN), with $460 million of debt, only $17 million in cash, and operating earnings that barely cover 70% of interest obligations!

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2. Revenue growth

Firms can always improve profitability through expense cutting, and stock multiples can ebb and flow, but ultimately a company must grow its sales in order to expand its bottom line sustainably. Revenue growth is catnip for money managers, and few stocks can maintain a high price/earnings multiple without it. MFI does not look for it, so many screened stocks have flat or declining sales -- see Apollo Group (APOL) or H&R Block (HRB). Not coincidentally, the stocks of these firms have the most limited upside potential.

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