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Can the Piotroski Method Improve Magic Formula Results?

2008 was an absolutely horrid year for stock investing. The S&P 500 was down nearly 40%. Even value stock strategies were pummeled, including the Magic Formula strategy. So it is intriguing that the American Association of Individual Investors found only one stock strategy that actually showed positive returns for 2008 - the Piotroski method.

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.

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.

These tests are all very simple to calculate, and indeed there are many Piotroski stock screeners out there, such as this free one, as well as one tied into the Magic Formula screen provided by Magic Formula Invesing EU.

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.

So, the current Magic Formula stocks with a Piotroski score of 8 or above:

Piotroski Score of '9' (Perfect):

GNI (Great Northern Iron Ore Properties)
PPD (Pre-Paid Legal)
MSFT (Microsoft)
FIX (Comfort Systems)

Piotroski Score of '8.5' (Very Good):

GTLS (Chart Industries)
MOS (Mosaic)
FLR (Fluor)
IPHS (Innophos Holdings)
JEC (Jacobs Engineering)
INT (World Fuel Services)

Piotroski Score of '8' (Good):

DISH (Dish Network)
TRA (Terra Industries)
CHKE (Cherokee)
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