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Joseph Piotroski is an former accounting professor at the University of Chicago, and an active value-based investor. He noticed when reviewing stocks with very low price-to-book value that many of them were in poor financial shape, unlikely to survive and deserving of their low valuation. Piotroski set out to devise a system to take these low price-to-book stock lists and mechanically filter out the ones that were unlikely to survive and prosper, leaving a number of potentially attractive investment opportunities.

Piotroski's method is very simple. A stock is scored by 9 different, and very simple, criteria that measure the company's performance between the past 2 years. The stock gets a '1' for each test it passes, and a '0' for each test it does not. If both years show identical values, a '0.5' can be awarded. At the end, all of the scores are added up to come up with the Piotroski score. In this scale, a '9' is a perfect score, passing all tests. '8' (and '8.5') are excellent scores worthy of consideration. Back-testing has found that choosing stocks with low valuations and Piotroski scores of 8 or 9 vastly outperforms the market.

The 9 tests are:

1. Net Income: '1' if last year's net income is positive, '0' if not.

2. Operating Cash Flow: '1' if last year's operating cash flow number is positive, '0' if not.

3. Return on Assets Increasing: '1' if last year's return on assets are greater than prior year, '0' if not.

4. Quality of Earnings: '1' if operating cash flow is greater than net income, '0' otherwise. This test can identify potential accounting issues, as cash flow is usually greater than net income due to depreciation and intangible asset amortization charges.

5. Long-term Debt vs. Assets: '1' if long-term debt to assets ratio is lower than year-ago number, or if long-term debt is 0. Is the company reducing it's debt relative to assets?

6. Current Ratio: '1' if short-term assets / short-term liabilities ratio is greater than previous year. Is the company getting financially stronger?

7. Shares Outstanding: '1' if outstanding shares is lower or the same as prior year, '0' otherwise. Is management buying back shares and being reasonable with options grants?

8. Gross Margin: '1' if gross margin from last year exceeds previous year, '0' otherwise. Has the company been able to maintain pricing power against cost of goods?

9. Asset Turnover: '1' if rise in revenues exceeds rise in total assets, '0' otherwise. This can identify unprofitable investments by management.

So what does the Piotroski method have to do with the Magic Formula Investing strategy? It's obvious that these tests are meant to filter out stocks with rather obvious reasons for a low price-to-book value, such as being unprofitable, being a declining business, or facing rising debt burdens. Some of these tests are automatically performed by the Magic Formula strategy. For example, test #1 would always pass, else the stock would have a negative earnings yield and never reach the MFI screen!

However, most of the other tests are indeed useful to Magic Formula investors. Tests #5 and #6 are good financial health measures, a problem with some MFI stocks. Tests #2 and #7 can red flag potential accounting oddities, and some of the others are measures of business momentum, which has been shown to improve value investing strategies. Therefore, it's interesting to calculate the Piotroski scores for stocks on the Magic Formula screen. The highest scores should clearly indicate a cheap stock price put on a quality company with relatively strong business momentum - a pretty solid recipe for success.

Taking a look at the 3 MFI screens covered by MagicDiligence (top 50 over 50 million, top 50 over 1 billion, top 30 over 3 billion), here are the stocks with a Piotroski score of 8 or above:

Piotroski Score of '9' (Perfect):

Activision Blizzard Inc (ATVI)
Career Education Corp (CECO)
Gannett Co Inc. (GCI)
KLA-Tencor, Inc. (KLAC)
Meredith Corp (MDP)
Power-One Inc. (PWER)
Veeco Instruments Inc (VECO)

Piotroski Score of '8.5' (Very Good):

Freeport-McMoran Copper & Gold Inc. (FCX)
Sauer-Danfoss Inc (SHS)
Teradyne Inc. (TER)

Piotroski Score of '8' (Good):

Apollo Group Inc (APOL)
Comtech Telecommunications Corp. (CMTL)
Cubic Corp (CUB)
Dell, Inc. (DELL)
Deluxe Corp (DLX)
DeVry Inc (DV)
Hewlett-Packard Co (HPQ)
Lexmark International Inc. (LXK)
Marvell Technology Group Ltd (MRVL)
MKS Instruments Inc (MKSI)
Northrop Grumman Corp (NOC)

Disclosure: Steve owns VECO, FCX, APOL, CUB, DELL, NOC

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Comments

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Posted by dweseb on 2011-11-30 11:23:50

I really like the way you've combined Piotroski's scores and Magic Formula. I've been tracking and use both for my investment decisions. Now, if someone would only address portfolio weighting of stocks, bonds, commodities, and cash during different phases of the business cycle, I think we could have a very robust investment strategy. We don't want to time the market, but even the good stocks take a hit when conditions are not favorable and PE's drop. I'd be interested in hearing your thoughts on this.

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Posted by Steve on 2011-12-01 11:37:04

Unfortunately, I don't really have any opinion on portfolio weighting - this is more of a stock site and less of a financial planning one. Most studies have shown time and again that trying to predict the business cycle is a futile exercise. For me, I'm most comfortable with stocks because that is what I feel I understand the best, and also has historically produced the best returns over time. Different people will have different goals, risk levels, priorities, etc, so there is probably no hard and fast rules for this.

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