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Melvin: Wait for Quality and Price to Meet

Editor's Note: This article was originally published at 3 p.m. EDT on Real Money on June 23. Sign up for a free trial of Real Money.

When I was researching yesterday's column about stocks with high returns on capital, I ran across a video of noted value investor Joel Greenblatt talking about how he uses this measure to select stocks. He mentioned that most of the stocks in his portfolio had a return on capital of 50% or more.

Now, that's a huge number and it reminds me that John Danaher, of private equity firm Leonard Green, said earlier this year that he confined his purchases to those companies that were growing earnings before interest, taxes, depreciation and amortization (EBITDA) at 50% a year or more. Companies that can earn those types of returns and growth should be compounding miracles for investors who buy them at the right prices.

The key is the right price. Greenblatt also said that the way to earn high returns is to find these superior companies and buy them when the market is giving them away for some reason. He prefers the metric of earnings yield but I suspect you can also use price to book and Enterprise Value (EV) to EBITDA.

Very few stocks are really cheap right now so most of the names I uncovered using a return of capital a screen are not going into my portfolio today. They are going to the very top of my watch list as stocks to buy in broad-market or sector declines. If one of these great companies stumbles and misses earnings or has some other one-off event that makes their stocks cheap enough to buy, I will be ready to pounce.

The list does include some fascinating companies, including two firearms companies. Sturm, Ruger (RGR - Get Report) makes the cut as it has had a return on capital of more than 100% over the last 12 months. While hoping to avoid any political landmines, I have to confess that my wife and I frequent the shooting range for target practice. Our preferred brand makes the grade: Smith & Wesson (SWHC - Get Report) has a return on capital of more than 75% right now. These stocks can trade on noises quite often. If they fall to cheaper valuations, they would be outstanding holdings for long-term investors.

One of the world's current growth industries is in providing of benefits under various government programs. Maximus (MMS - Get Report) is perfectly positioned to take advantage of this powerful trend. The company provides services to various agencies in the  U.S., Australia, Canada, the U.K. and Saudi Arabia. Programs include the Affordable Care Act, Medicaid, Children's Health Insurance Program, Medicare and the Health Insurance British Columbia Program. They also provide a wide range of administrative support and case management services for federal, national, state, and county human services agencies and cover welfare programs, child support case management and education consulting. The company has a triple-digit return on capital (ROC) right now and has averaged a more than 50% ROC for the past decade.

One of the companies that made the cut of the Leonard Green EBITDA growth measure is also on this list. Liquidity Services (LQDT - Get Report) operates online auction marketplaces for sellers and buyers of surplus, salvage and scrap assets. The stock tumbled when a key Defense Department liquidation contract was halted but this is still a solid company.

The company works with NBC to liquidate surplus equipment -- for example, the broadcast, IT and electronic test and measurement equipment used at the Sochi Olympics. I went onto the website earlier today and was so impressed I signed up as a buyer. The company is liquidating surplus inventories of everything from ladies dresses to computer equipment. The ROC is over 500% and has averaged that level for the past decade. This stock is way up on my watch list and I hope it tumbles further so I can own the shares for a long time.

There are some interesting names of the list of companies with a very high return on capital that will be worth owning at the right price. It is frustrating at times to wait for quality and price to meet, but it is worth the patience and discipline required.

At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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