High Piotroski Scores in Magic Formula Investing

NEW YORK ( MagicDiligence.com) -- 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 ratios 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 nine different criteria that measure the company's performance between the past two years. The stock gets a "1" for each test it passes, and a "0" for each test it does not. 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 while "8" is also an excellent score 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 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 (i.e. "non-cash") 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 revenue 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 (MFI) strategy? It's obvious 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 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 three 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. The calculations were done using the excellent tool at Graham Investor.

  • Piotroski Score of '9' (Perfect):
  • Hewlett-Packard ( HPQ)

Piotroski Score of '8' (Good):
  • Acacia Research ( ACTG)
  • Applied Materials ( AMAT)
  • Dolby Laboratories ( DLB)
  • H&R Block ( HRB)
  • KLA-Tencor ( KLAC)
  • Kronos Worldwide ( KRO)
  • LML Payment Systems ( LMLP)
  • Lender Processing Services ( LPS)
  • Mediware Information Systems ( MEDW)
  • Seagate Technology ( STX)
  • United Therapeutics ( UTHR)

On the other hand, Piotroski recommended shorting stocks with a score of 2 or lower. Shorting is not a part of the Magic Formula strategy but this may be a red flag to pay extra close attention to these stocks before considering a buy. Only 3 MFI stocks meet this criteria at present:

Piotroski Score of '2' (Bad!):
  • Gentiva Health Services ( GTIV)
  • Interpublic Group ( IPG)
  • Lear ( LEA)

I run this article at least once a year, and it is always interesting to see what the results actually are. Here are the one-year results of the Piotroski article from last February:
  • Dell ( DELL) +15.2%
  • DeVry ( DV) -30.6%
  • Visa ( V) +60.8%
  • Mednax ( MD) +26.6%
  • Buckle ( BKE) +25.6%
  • Oshkosh ( OSK) -37.1%
  • Aeropostale ( ARO) -31.1%
  • Lincoln Educational Services ( LINC) -37.0%
  • Nu Skin Enterprises ( NUS) +68.1%
  • Seagate Technology ( STX) +119.3%
  • Teradyne ( TER) -7.2%
  • USA Mobility ( USMO) -2.6%
  • Veeco Instruments ( VECO) -36.0%

As usual, a mixed bag of individual stocks, but again a solid result collectively. The average gain here is +10.3%, far outperforming the S&P 500's +6.2% performance over the same one-year period. We've seen good results using the Piotroski method as an additional filter on top of the Magic Formula® screens in the handful of times it has been tested.

As of the time of publication the author owned shares of UTHR.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

This contributor reads:
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On Twitter, this contributor follows:
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