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For Investment Success, Choose CRAP Stocks

The safest and most reliable path to stock market success is to invest in CRAP stocks.

The strategy we follow, Joel Greenblatt's Magic FormulaŽ Investing (MFI), 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? 4 points of research:

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.

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. But, 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 5 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!

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.

On the other hand, finding an MFI stock with good revenue growth trends could very well indicate that the market's valuation has trailed the company's growth trajectory, creating an attractive investment candidate. This is especially true if rapid sales growth is projected to continue. C&J Energy Services (CJES) grew sales 210% in 2011 and is projected to grow another 50% this year, yet carries a price-to-earnings multiple under 6!

Advantages over the competition

Competition will always be a keen risk, so look for firms that have structural competitive advantages. Microsoft (MSFT) software is a lynchpin of most businesses worldwide and would be a gigantic hassle to switch away from, creating high switching costs. Tremendous scale, razor thin margins, and an established oligarchy create huge barriers to entry for any prospective competitors of drug distributor AmerisourceBergen (ABC). Regulatory patent protections prevent direct competition for Gilead's (GILD) HIV drug portfolio. All of these factors can help protect pricing, market share, and profitability from competitors.

On the other hand, a firm like Chemed (CHE) has almost no structural advantages. Both their plumbing and hospice businesses face thousands of competitors, and both have low barriers to entry for new entrants.

Priced well below a reasonable fair value estimate

Here is where MFI helps us the most, as a high earnings yield (basically the inverse of a low P/E) is one of the compentents of the screen. All of these stocks are cheap against trailing earnings. But is the valuation warranted based on the prospect of a long-term decline in revenues and profits? Is it warranted based on horrific financial health? Is it warranted based on competitors (or new government regulations) eating into their business? To figure this stuff out, one needs to sit down and estimate a fair value for the business, based on reasonable estimates of future results and valuation ranges.

Conservatively managed. Revenue growth. Advantages over the competition. Priced well below fair value. When digging through heaps of stock opportunities, always be on the lookout for CRAP. I've got my shovel. How about you?

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