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The mission of MagicDiligence is to weed out the "bad" Magic Formula stocks and promote the "good" ones. The Top Buys list are the "good" stocks, but it's useful to go through some examples of "bad" stocks to see how the weeding process works.

Before we do, it should be mentioned that not all of these will prove to be poor investments. In fact, it's likely that the Magic Formula's stellar performance is somewhat due to these kinds of companies successfully adapting and overcoming market and competitive challenges, defying their valuation. However, the greatest potential for returns with the lowest risk comes from strong companies with durable competitive advantages.

As mentioned in several places here, there are 4 primary criteria used to filter through the Magic Formula list. Below are each criteria and an example of a current Magic Formula stock that gets thrown away based on it.

1) Financially healthy with strong, reliable cash flows, reasonable debt, and durable competitive advantages.

An example of a stock not meeting this criteria is Idearc (IAR). This company was recently spun off from Verizon, and they publish the yellow pages books in areas where Verizon is the local carrier. They also run yellowpages.com. The problem with IAR is that Verizon saddled the company with a large debt load. Debt interest eats up 50% of operating earnings, leaving the company with a paltry 2.0 coverage ratio. This leaves very little wiggle room if something goes wrong in the business. What's more, advertising dollars are trending online, phone directories are more easily searched online, and cell phones are increasingly more capable of accessing online directories. This is a bad combination for Idearc's future prospects, and that's reflected in the huge drop they suffered today. MagicDiligence threw Idearc away from the start.

2) Are not the beneficiary of a one-time "fad" product.

Most Magic Formula investors will shake their head at this one - Heely's (HLYS) is a classic fad product company. The company had a huge breakthrough last fall with their sneaker/rollerskate combination shoes. But the demographic - pre-teens - is a notoriously fickle group where fads go to rise and fall, often within the span of a year or two. Heely's has given no indication they can follow up with another great product to maintain earnings. The ROTC is based on last year's fad, and the EBIT/EV is based on the bleak outlook going forward. MagicDiligence doubts Heely's will ever regain last year's success, and so they were rejected.

3) Have experienced and trustworthy management, by all available indications.

This one is more subjective, and probably accounts for the fewest discards. One example is King Pharmaceuticals (KG). The company has constantly had to take one time charges and restate earnings due to accounting issues. The question here is, can we trust the financial results on which the Magic Formula statistics are based? Until proven otherwise, play it safe and look elsewhere to invest.

This rule is particularly important for small cap stocks. Small companies are more dependent on good management to grow and survive. MagicDiligence looks for large insider ownership and good results for years before even considering recommending a micro or small cap company.

4) Are not operating in a declining industry with poor future prospects.

Can you believe there are companies that still make pagers, over 10 years after cell phones became mainstream? There are, and one of them is a perennial top 25 Magic Formula stock - USA Mobility (USMO). Pagers still exist, but are quickly losing their price advantages and will soon go the way of the telegram, telegraph, and carrier pigeon. USMO is facing quickly declining revenues and without sales growth, no company can grow earnings for very long. USMO was an easy discard.

Not all Magic Formula companies are this cut-and-dry. For example, many financially strong companies are discarded because they operate in very competitive industries with few sustainable advantages.

Steve owns no position in any stocks discussed in this article.

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