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Magic Formula Investing, invented by Joel Greenblatt in The Little Book that Beats the Market, is designed to find stocks with two attributes: A high earnings yield (indicating a cheap price), and high returns on capital (indicating a good business). However, if you look at the official screens regularly, it becomes apparent that often several stocks within an individual industry sector will all appear around the same time. This indicates that the sector, not necessarily the individual stocks, is out of favor with investors.

This is important for two reasons. First, buying into sectors out-of-favor is a good contrarian strategy for value investors. The market is one of cycles, and when one industry sector is up, others are down... but you can be sure they will reverse places in time. For example, oil and gas stocks were all the rage just a year ago as crude prices soared, but today sell for 40% or more less than they did at this point in 2008.

But perhaps more important is that the Magic Formula strategy is excellent at digging out the very best competitors within these industry sectors that are out of favor. While buying into a sold-off sector is good strategy, buying only the very best players in that sold-off sector is an even better one. The MagicDiligence Top Buys portfolio takes advantage of this strategy often. One example over the past year was in recreational vehicle (RV) sales. While all the major players had low stock prices, the Magic Formula (and MagicDiligence) pulled out the very best: Thor Industries (NYSE:THO). While competitors like Fleetwood (FLE) and Coachmen (NASDAQ:COA) now face bankruptcy, Thor vastly outperformed the market as it now stands to gain serious market share.

Here's the list of industry sectors with the most stocks in the Magic Formula list as of yesterday. By definition, over the past year they have delivered outstanding returns on capital but are now priced at a discount. Are those returns on capital due to cyclical market forces or are they truly great businesses? Are the cheap prices truly cheap when measured against the near-term outlook? Those are the questions MagicDiligence is here to answer!

Industry# StocksTickers
Engineering & Construction6EME FIX FLR FWLT JEC KBR
Business Applications6ADSK DIVX DOX MSFT ULCM VSNT
Wireless Equipment4AIRV GRMN HRS QXM
Media Conglomerates3CTCM TWX VIA-B
Aerospace & Defense3GD NOC RTN

Disclosure: Steve owns PFE, VSNT, MSFT, ADSK

Source: How ROE Shows Which Companies are Undervalued in an Industry