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)

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