Professor's Value Strategy Picks Winners

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NEW YORK (TheStreet) -- Joseph Piotroski is a former accounting professor at the University of Chicago and an active value investor. He noticed when reviewing stocks with very low price-to-book value, many 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 prosper, leaving a number of potentially attractive investment opportunities.

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

The nine 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):

Dell(DELL)

DeVry(DV)

Visa(V)

Piotroski Score of "8.5" (Very Good):

Altria(MO)

The Buckle(BKE)

Oshkosh(OSK)

Piotroski Score of "8" (Good):

Aeropostale(ARO)

Lincoln Education(LINC)

Nu Skin(NUS)

Seagate(STX)

Teradyne(TER)

USA Mobility(USMO)

Veeco Instruments(VECO)

Just for a recent frame of reference, I looked at an article I ran last April detailing the results of an identical screen. So how did this group perform over the last 10 months? Let's see:

Hansen Natural(HANS) +35.0%

CA(CA) +4.4%

Corinthian Colleges(COCO) -72.9%

GT Solar(SOLR) +98.5%

Eli Lilly(LLY) -4.4%

Sturm Ruger(RGR) +7.7%

Continucare(CNU) +34.6%

Deckers Outdoor(DECK) +95.5%

McKesson(MCK) +19.8%

Pervasive Software(PVSW) +9.1%

Raytheon(RTN) -14.4%

USA Mobility(USMO) +23.3%

ValueClick(VCLK) +42.0%

A mixed bag, to be sure. However, the average performance of the group was 21.4%, far better than the S&P 500's 9.3% performance. A similar performance from the current group would certainly be satisfactory to investors.

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