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What Is the Stock Market’s ‘Magic Formula’ Telling Us to Buy?

Sunday - 4/7/2013, 9:09pm  ET

Gotham Asset Management founder Joel Greenblatt is said to use a more cerebral approach to picking stocks. As a professor at Columbia Business School and author of several books on value investing and methods of picking stocks, we’re guessing that Mr. Greenblatt’s top five stock picks are chosen on more than just P/E ratios and growth expectations. His fund is nearly evenly distributed between most sectors of the market, but the majority is predominantly in consumer goods, services and technology. Let’s look at the top five stocks in Gotham Asset Management’s equity portfolio.

Topping the list is Raytheon . The sequestration coupled with a downbeat earnings report in the fourth quarter drove the stock sharply lower early in the year. Most of the losses have been regained, but there just haven’t been any new bullish developments to elevate the stock over $60 since 2008. However, all the elements for a break higher are there—the stock is undervalued compared to its nearest competitor Boeing, and with the exception of Northrop Grumman, Raytheon has the lowest debt-to-equity ratio in the defense sector. The only thing that is currently weighing on the stock are the political machinations in Washington that are holding the entire defense industry hostage.

At number two is United Therapeutics , which is one of those companies that’s hard to find something wrong about. The company recently reported very strong earnings—revenue was up for 2012 from $195 million to $244 million, which boosted earnings to $1.65 per share from $0.79 year-over-year. The stock is cheap compared to its competitors in this sector, Novo Nordisk and Roche, and has a very low debt-to-equity position. Since adding United Therapeutics back into his portfolio during the second quarter of 2011, Greenblatt has increased his holdings by 1,566%, and given the fundamentals of this stock, it has obviously been a smart move. Currently trading at a two-year high, the stock is forecast to trend higher to test short-term resistance at $66 a pop.

Cisco Systems is third in this top five, and has come under intense profit-taking pressure on the heels of a downgrade from market perform to underperform, as well as industry-wide pressure following disappointing earnings from Oracle. Cisco’s downgrade is in response to the company’s transition to a “software and service-centric business model,” but for the aspiring value-tech investor, the stock is the better buy against competitors like Ericsson, Juniper, and Alcatel-Lucent, to name a few.

At number four is GameStop . If you have a gamer in the family (or if you’re one yourself), GameStop is synonymous with used video games, consoles and components. Unfortunately, since nearly half of GameStop’s sales come from the realm of used games, this might ultimately prove to be its downfall, as console makers such as Microsoft and Sony have at least been rumored to be considering the restriction of used games on next-gen platforms. Loyal customers of GameStop have voiced their support by claiming they will not buy any console that restricts the use of pre-owned games, but experience has shown that for gamers, their loyalty ends with their need for the best graphics, more processing power and more features. Unless GameStop can quickly figure out a way to compete with digital game sales, it may become a dinosaur, so to speak, in the rapidly evolving video game market.

At number five is Deluxe Corp , whose main business is printed personalized products such as checks, mailing labels and promotional items. The company may not be very glamorous, but it has put in a very solid performance this year and has increased its bottom line from $144 million to $170 million. Insiders have been buying the stock, and analysts recommend a buy, with an expected test of $42.60 before profit taking comes into play. Although there are low barriers to entry in this market, and even Wal-Mart is offering check-printing services, for a strict value investor in this sector, Deluxe Corp is the better buy.

Value investing, technically speaking, is defined as weighing stocks on a “calculation of each stock’s absolute and relative value” compared to other peers in the sector. Of these top five stock picks in Greenblatt’s equity portfolio, there are competitors to each that may have better name recognition or more impressive revenue growth.

Still, Gotham Asset Management, a proponent of value investing, does not seem to be looking for a leader in each industry, but rather a so-called “second born,” like Deluxe, Raytheon, Cisco or United Therapeutics that has consistent and predictable growth. GameStop is an industry-leader in the used game segment, but with the secular headwinds it faces, we can include this company in the same group.

Although there are some positions that we may see reduced or eliminated over the next few quarters, most are very strong performers that will likely remain in Gotham’s portfolio for a while longer.

This article was originally published as What Is the Stock Market’s ‘Magic Formula’ Telling Us to Buy?on Fool.com

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