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2 Magic Formula Stocks You Should Not Buy

|Includes: Cornerstone Therapeutics Inc. (CRTX), VCI

Joel Greenblatt's Magic Formula® Investing (NASDAQ:MFI) screening methodology is an excellent and simple way to find great undervalued stocks, but occasionally it will screen special situation stocks that are best avoided by investors. Earlier this week, we highlighted one of its stocks that is almost certainly headed to $0 in the next few years. Today, I want to point out two additional current MFI stocks that are almost guaranteed to have zero upside from their current prices. They can also be discarded as candidates for purchase.

How to Make Quick Money from Value Stocks

Mr. Greenblatt accurately pointed out in The Little Book that Beats the Market all of the good things that can happen to undervalued stocks:

  • Fund managers and individual investors realize they are cheap and buy.
  • The company's management is able to buy back large quantities of shares at low prices.
  • Another company sees potential to acquire a competitor or complimentary asset at an attractive price.

All of these send stock prices up, but the last one has the most immediate impact. The average M&A deal is at a 20-30% premium above market prices, a large and immediate windfall for shareholders.

MFI screens its fair share of buyout candidates. In 2013, we saw the buyouts of screen members Warner Chilcott (40% premium), and Dell (about 20% when announced), just to name a few.

In 2014, we already have two MFI stocks lined up to be acquired very soon - the 2 I want to tell you about here.

This Stock Bored Me to Death, But I Still Added It

Valassis Communications (NYSE:VCI) is an advertising company that produces the RedPlum ad and coupon mailer, as well as the 4-color coupon booklets in the Sunday paper and a variety of digital coupon services. Boring and low growth? Yes. Highly profitable, cash generating, and shareholder friendly? YES!

Combined with a low valuation at the time, that's why MagicDiligence owned Valassis when the announcement came through in December that it would be purchased by Harland Clarke for $34/share, about an 18% premium. The stock immediately shot up and has now settled almost exactly to the offer price. With the tender offer set to end in early February, investing in Valassis at this point doesn't make much sense.

How to Steal a Growing Pharmaceutical Firm

Imagine a small pharmaceutical firm, growing revenues at an over 40% year-over-year clip, with 3 recently launched new products that could each add 20% to sales, 29% profit margins, and tremendous free cash flow generation. What would you pay for that?

Market P/E multiples for big pharma are around 17-20. For growing bio-techs, like Gilead (NASDAQ:GILD), the multiple is over 45! Surely a firm, even a small one, with the above kind of numbers should command at least a 20 P/E at buyout, right?

Well, no - not if you are Cornerstone Therapeutics (NASDAQ:CRTX). We wrote about this stock in detail a few months ago, and the conclusion still stands: shareholders got fleeced on this price. Despite a wave of lawsuits, I don't see Chiesi's $9.50/share offer changing. That's a forward P/E ratio of about 11.5! With the stock currently trading at 7 cents over the offer price, only extremely wishful thinking justifies an investment at this point.

Get In Before, Not After!

Mergers and acquisitions are a great way to make big - and quick - bucks from value stocks, and history has shown that MFI is a great strategy for finding buyout candidates. The nature of the screen to highlight small, undervalued, financially healthy firms should always make this the case.

There are only 50 stocks in the most inclusive Magic Formula® screen, and this week we've eliminated 3 from consideration - not bad. But what are the best ones to, you know, actually BUY right now? Ones that just may be the next to be acquired at a hefty premium? That's what our Top Buys picks service is all about!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.