Every year, Forbes creates a list of the top 200 best small companies in America. To be eligible for the list, a company must have annual revenue between $5 and $750 million, be publicly traded for at least a year, and have a stock price of at least $5. The rankings are done based on earnings growth, sales growth, and return on equity. Forbes has found that this group of stocks has outperformed the benchmark Russell 2000 of small stocks by about 10% annually.

This list is especially interesting for Magic Formula investors, as a staple of MFI is purchasing small-cap stocks, which are often under-followed and thus inefficiently priced in the market. Taking the Forbes list and pulling out the current Magic Formula stocks could find us some attractive investment ideas from the number of declining businesses or cyclical entities on the screen. Here is a table of current MFI stocks that appear in the top 200 list:

Time Warner (TWX) is one of the largest media conglomerates in the world, with four distinct operating units. Cable Networks is the largest portion of the company, driving about half of operating earnings. This unit runs some of the most widely distributed and largest audience channels in cable, including TBS, TNT, CNN, and HBO. AOL, representing just under a quarter of profits, is the infamous Internet company that derives most of its income from dial-up service, but also has a sizable advertising business and operates numerous highly-trafficked sites like MapQuest and AIM (AOL Instant Messaging). Filmed Entertainment is the movie arm, consisting of the Warner Brothers and New Line Cinema studios, providing about 17% of profits, although this is a cyclical business. Finally, Publishing, representing the remaining 10% or so of profits, produces such well known and widely circulated magazines as Time, People, Sports Illustrated, and Fortune.

The Time Warner of today is significantly different than the Time Warner of just 10 months ago, as Time Warner Cable (TWC) was spun off in March. Before the spin, TWC contributed close to 25% of sales. The Time Warner of 3 months from now will be significantly different from today, as AOL will be spun off in December. That is quite a transformation in a single year, with the company jettisoning over a third of total revenues! New CEO Jeffrey Bewkes, a veteran of Time Warner's cable channel arm, has wasted no time in the long overdue breakup. The goal is to transition Time Warner into more of a pure play on content, similar to MagicDiligence Top Buy Viacom (VIA.B).

It should come as little surprise that many stocks that make it into the Magic Formula Investing [MFI] screen are attractive acquisition targets. Many, if not most, are good businesses selling at cheap prices, exactly what the screen is designed to find. When you have quality selling cheap, not only individual investors but business managers, both public and private, take notice as well. Particularly if the screened business is one that is a current or potential competitor, or a business that nicely compliments current operations, it makes sense to acquire it at a favorable price. When this happens, investors reap big rewards in short periods of time.

Of course, there is the other side of the coin too - declining businesses or heavy cyclicals can find their way onto the screen as well, usually well into the downside. With these firms we need to be very careful - too much debt can land them in bankruptcy court. Unfortunately, MFI has turned up a few of these as well. Let's take a look at some individual "buyouts and bankruptcies" on the MFI screen in 2009.

Sturm, Ruger & Company (RGR) is a firearms manufacturer that makes and markets four different kinds of firearms: Rifles, shotguns, pistols, and revolvers. The company also produces investment castings for third-party sale when there is excess capacity not needed for its own products. Products are sold mainly to independent wholesale distributors, who then resell to retailers primarily in hunting and sporting markets. Ruger is basically a U.S.-only company, with less than 4% of sales coming via export.

Ruger's appearance on the Magic Formula screen is a classic case of fooling the parameters due to a cyclical situation - this time the widely reported "gun boom" that started in the forth quarter of 2008 right after the election of President Obama and has continued through most of 2009.

Cephalon (CEPH) specializes in bio-pharmaceuticals that target central nervous system (CNS) disorders, pain treatments, and oncology (cancer). The star product over the past few years has been Provigil, a treatment for sleep disorders, that has accounted for about half of sales. Other significant drugs in the portfolio are Fentora and Actiq (the former a replacement for the latter), which account for nearly 25% of sales. Fentora and Actiq are designed to treat cancer-related pain. The final meaningful drug is Treanda, a treatment for leukemia and lymphoma, although Cephalon also has numerous other smaller formulations that target conditions such as seizures and spasms.

Cephalon's growth will largely be tied to its newest product: Nuvigil, a replacement for Provigil which is facing imminent generic competition and loses patent protection in the next few years. Nuvigil has several advantages over the older drug, including fewer side effects and better effectiveness. Best of all for Cephalon, the drug was just launched this summer and offers over 10 years of patent protection. Nuvigil is set to be the engine of growth, particularly through expanded indications for jet lag, bipolar depression, schizophrenia, Parkinson's disease, and others. If all goes to plan, Cephalon will be able to migrate Provigil patients into Nuvigil, protecting them from competitors, and gain new patients through the expanded label.

In this first edition of a recurring series, we will take a number of competitors in the same industry, all current Magic Formula stocks, and compare the relative merits of investment of both the industry itself and then the individual stocks within them. Today we'll start with an industry that is practically fully represented in MFI at the time: pharmaceutical distribution.

The Industry

World Fuel Services (INT) is a provider of, you guessed it, fuel and related services to the marine, aviation, and land vehicle market, which is how the company is segmented. The marine segment (55% of sales, 51% of profits) and aviation (33%, 40%) provide similar services at seaports and airports. International container and tanker fleets in marine, and airlines and cargo carrigers in aviation both contract with World Fuel to provide the convenience of a single source supplier, procurement outsourcing, quality control, price hedging, logistics, offering credit, and providing ancillary services like flight plans and weather reports.

In general, you can think of INT as a fuel reseller and broker, earning the lion's share of profits on the spread between fuel acquisition costs and resale pricing, as well as about 20% on other services. The land segment (12%, 9%) is similar. This division mainly serves as a wholesale gasoline and diesel provider to service stations both in the U.S. and overseas. A handful of service stations are directly operated by the company.

Aeropostale (ARO) is one of the numerous teen clothing retailers you see at pretty much every decent-sized mall in America. As of August, the company operated 888 Aeropostale stores in the U.S., 38 in Canada, and 9 "P.S. from Aeropostale" concept stores in 2 states.

The target demographic is the 14 to 17 year old age group, and the company utilizes its own fashions and designs exclusively. Aeropostale differentiates through targeting lower price points and using more promotional pricing throughout the year than competitors like American Eagle (AEO) or Abercrombie & Fitch (ANF).

For most investors that seek to actively learn about the trade, one piece of advice seems to come up over and over: "invest with a long-term horizon". There are certainly many good reasons for this. For one, it is much easier to see and predict long-term business trends and advantages then it is to predict what is going to happen over the next few months or weeks (in most cases). Investing with a long-term horizon also prevents unwise speculation, avoids paying hefty commissions and taxes, and focuses the stock investor on the business fundamentals - financial health, growth potential, competitive position, price - that are key to finding winning investments.

There is tangible proof that, over the long term, investing in stocks provides the best returns of any investment vehicle. Jeremy Siegel, a Wharton professor and well known financial commentator, showed in his book The Future for Investors (MagicDiligence review) how value-based strategies such as the Dow 10 ("Dogs of the Dow") and dividend re-investment outperform the market over long periods of time. In his other, and more well-known book, Stocks for the Long Run, Siegel goes all the way back to the early 1800's to show how stocks have outperformed bonds and commodities handily over long periods of time. John Bogle, the founder of Vanguard, made his fortune espousing an indexing strategy, showing how over the long run the stock market has provided about 10-12% annual gain on investment (The Little Book of Common Sense Investing is a short, sweet read on his philosophy). No less an authority than Warren Buffett has said that "forever" is his favorite stock holding period.

DynCorp International Corp. (DCP) is a government contractor that operates in three business segments:

Global Stabilization and Development Solutions (GSDS, 36% of revenues, 30% of operating profits) provides policing and police training, security and personal protection for government officials and diplomats, and military base logistics such as electricity, water, sewage, and laundry under the recently awarded Logistics Civil Augmentation Program ((LOGCAP)) IV program.

Dun & Bradstreet (DNB) is a provider of business information with a history dating back over 165 years. Today's company has 3 business segments. Risk Management, driving about 64% of sales, provides reports and other information products that allow companies to determine creditworthiness of potential customers. This unit may best be thought of as a Moody's (MCO) or S&P (MHP) rating agency for private companies... In fact Moody's was spun off from the "old" Dun & Bradstreet in 2000.

The second business unit is Supply, Sales, and Marketing (28% of sales), which provides information to help customers identify market segments, profile potential customers, build mailing lists, and evaluate current and potential suppliers. The third and final segment is Internet Solutions, consisting mainly of Hoover's, which has basic information on thousands of public and private companies, and AllBusiness.com, a resource and advice portal for business managers.

Warren Buffett is a legend in the investing world. He's been called "The World's Most Successful Investor" for good reason. Currently the world's second richest man, with a net worth exceeding $40 billion dollars, his fortune has been built almost exclusively through business acquisition, both entire companies and equity positions.

Buffett started as a disciple of value investing legend Ben Graham, the author of The Intelligent Investor, which Buffett has called the best book on investing ever written. He formed several partnerships in the late 1950's, and in the mid-1960's acquired New England textile manufacturer Berkshire Hathaway (BRK.A). Eventually, he and his partner Charlie Munger morphed Berkshire into an investment vehicle, acquiring excellent businesses like See's Candy and GEICO insurance as well as stock positions in large companies like Coca-Cola (KO) and Gillette (PG), among others.

United Online (UNTD) is a sort of "mini-conglomerate" with three lines of business. The first, FTD, markets floral and gift products over the internet (www.ftd.com) and through a toll-free telephone number (1-800-SEND-FTD), and these orders are then fulfilled by one of the company's large network of local florists. While FTD is a U.S. concern, the subsidiary also has a similar business in the U.K. and Ireland known as Interflora. FTD provided 57% of United Online's revenue in the most recent quarter and was only acquired by the company a year ago.

The second line is the online social networking and loyalty marketing, namely Classmates (www.classmates.com) and MyPoints (www.mypoints.com). Classmates is a 50 million strong social network organized mainly by academic institutions attended. While most members just list their information with a free account, a paid account is required to contact former acquaintances. MyPoints is a "pay to click" site where people get points towards rewards for taking surveys, responding to email offers, and so forth. This business segment delivers around 22% of total revenues.

Questcor Pharmaceuticals (QCOR) produces and markets for all practical purposes a single product: H.P. Acthar Gel. Acthar is an injectable treatment for inflammatory disorders, particularly multiple sclerosis (MS) and infantile spasms (IS) in children. The company also markets Doral for insomnia, but Acthar contributes about 99% of all revenues, making an analysis of Questcor equivalent to an analysis of the outlook for sales of Acthar.

The drug, and its relationship with this company, have an interesting history. Acthar is not a new drug - it was first synthesized way back in the 1940's from pig pituitary glands. Eventually the drug was owned by Aventis, which nearly discontinued production in the mid-1990's due to poor sales. However, pediatricians objected, as there were few choices for treating IS, and Acthar was (and still is) the first option for treatment. Questcor acquired the rights to Acthar in 2001. With such low volumes and a low price, Acthar did not provide many benefits to Questcor. The company continued to be unprofitable.

Corus Entertainment (CJR) is one of Canada's largest media and entertainment companies. Generally speaking, Corus operates two business segments. Radio (about 20% of operating profit) consists of 53 radio stations across Canada, covering a variety of music genres and station formats, making it the second largest radio operator in the country after Astral Media with about a 28% market share.

The second segment is Television (80% of operating profits), which can be further broken down into specialty and premium television networks (channels) and content creation. On the channel side, Corus completely or partially owns some well-known networks such as TELETOON, YTV, W Network, Movie Central, and Encore Avenue. Corus also owns a handful of broadcast TV stations.

CGI Group (GIB) is Canada's largest IT consulting firm, based in Montreal, and dominates the consulting market for most of the top-shelf Canadian companies. CGI's services are concentrated into three basic areas: Consulting, systems integration, and business process outsourcing. The company has focused on a few well-defined industries to target their services, namely financial services, telecommunications, retail, manufacturing, and healthcare. The largest geographic contributor to revenues is Canada, although the U.S. market provides about a third of sales (CGI entered the U.S. in 2004).

Consulting and outsourcing is a huge market with a lot of nooks and crannies and an absolute tidal wave of competition. CGI Group focuses mainly on large scale systems integration and their outsourcing contracts, which puts them into direct competition with some large competitors like Accenture (ACN), IBM (IBM), Computer Sciences (CSC), and others. A durable competitive position in such a competitive and (in many cases) discretionary market is difficult to achieve.

In the previous article, Debt in Business Analysis, MagicDiligence did an overview of analyzing a prospective investment's debt burden. In this article, we'll go through a Magic Formula example that covers a lot of the bases: Deluxe Corporation (DLX).

Before we begin, it's important to set a context for analyzing the debt. Is this a heavily cyclical company that suffers huge swings in revenue and profitability over short periods of time, or does it have fairly stable sales and profit margins? What is the near and medium term prospects for earnings growth? These are both important points - cyclicals and declining businesses obviously are riskier if they have worrisome debt burdens.

One of the most important things to look at when analyzing a prospective investment is the financial health of the business. Companies with a lot of debt and little cash flow are candidates for bankruptcy, leaving your investment worth nothing, regardless of how much you paid per share of stock. On the other hand, strategic debt can often help greatly improve a business's growth rate, and is almost required for start-up and early-stage companies. In this article, I'll go over 5 basic questions related to analyzing a company's debt burden, including what it is, and what is good or bad debt. In a follow up article, I'll go through a Magic Formula example to illustrate the process.

1) What kinds of debt do businesses use?

Many MagicDiligence readers are probably familiar with The Motley Fool's CAPS service, and for those of you who are not, I highly recommend checking it out. In essence, CAPS is the world's largest free stock picking game. Every player can rate any stock to outperform or underperform the market, for a variety of time periods from "a few months" to "5 years or more". The rating is then assigned a beginning stock price, and the percentage change in the stock price is tracked vs. the change in S&P 500 (including dividends). Picks outperforming the S&P 500 get a positive score, and underperformers get a negative score. Then all players are assigned a rating based on a number of factors, including total overall score, pick accuracy, and so forth. Like high school, the player score is between 0-100, and the higher the better.

For those interested, you can check out MagicDiligence's CAPS page, where I usually post ratings and reviews on the publicly available stocks here at the site.

Note: Hillenbrand recently fell off the Magic Formula screen after a long run. It is likely just off the screen and could return any day.

Hillenbrand (HI) is the parent of its only subsidiary, Batesville Casket. Batesville Casket is the largest casket provider in the United States, and sells other funeral products like urns, funeral home displays, and other funeral services. Batesville has a long and distinguished history of being the top player in the casket industry, with a well established and well-known brand. Hillenbrand as it exists today was spun off from Hill-Rom (HRC) in April 2008.