In the past 2 articles we looked at the 2 most popular screens. The Greenblatt Magic Formula screen looks for good quality companies whose shares can be purchased at bargain prices. The Piotroski screen looks for low price-to-book value stocks with improving fundamentals. While both screens allow investors to achieve significant returns if used as designed, they each have their flaws.
The Piotroski screen starts by selecting the top 20% companies with the highest book-to-market ratio. Numerous studies have proven low book-to-market strategies to deliver high returns. These studies also showed that the success of such a strategy relies on the strong performance of only a few firms, while the majority of other firms in that selection showed below market performance. Piotroski designed the F-score to filter out the companies with improving fundamentals, which had a significantly positive impact on overall performance.
Seasoned investors see a fundamental flaw in this approach. According to Peter Lynch, book value gets a lot of attention as it's very easy to find and makes sense to most people. A book-to-market value of 2 means you're buying stock at half price. In reality, stated book price bears little relationship to the actual price of the company. In addition to this, average book-to-market typically varies across different industries. So starting off by selecting the lowest book-to-market stocks might not be the best idea.
The Greenblatt Magic formula has its flaws too. It selects stocks based on an equally weighted ranking of Earnings Yield and ROIC, but it completely ignores whether the prospects of the company are improving or not. In the last article one of the stocks selected was CTC Media, a company that has lost more than 90% of its value during the last 5 years. Its Earnings Yield and ROIC might be high when compared to other companies, but its fundamentals continue to deteriorate.
So why not combine the 2 strategies? We came up with a screen that starts by selecting the top 20% Magic Formula stocks and then filters out only stocks with a Piotroski F-Score of 7 or higher. We called it the Magic formula Best Selection and it's available as a template. To fine tune the screener, I applied the same additional filters used in the previous article:
- I only selected companies with a primary listing on stock markets in North America (United States and Canada)
- I filtered out companies that did not post any quarterly results ending in the last 6 months.
- I set a minimum daily trading value of 10K Euro.
- I selected all sectors but unchecked financial companies and utilities. Additionally I filtered out oil & gas companies and materials.
- I selected the following stock markets: CA - Toronto stock exchange; CA - TSX venture exchange; US - Nyse arca; US - Nyse amex equities; US - Nasdaq capital market; US - Nasdaq/ngs (global select market); US - Nasdaq/nms (global market); MX - Mexican stock exchange. I made sure not to include the OTC markets and pink sheets.
The full list is available in the screenshot above but here's the top 5:
- Sanderson Farms is the third largest poultry producer in the United States.
- Multi-Fineline Electronix or MFLEX provides printed circuits and assemblies to the electronics industry.
- Newlink Genetics is a biopharmaceutical company that develops immunotherapeutic products to improve treatment options for patients with cancer.
- Outerwall provides a network of movie and game rental kiosks as well as coin-cashing machines.
- Neustar provides real-time cloud-based information & analysis to the Internet, telecom, financial, media & advertising and retail industries.
In the next article, we will focus on a screen we developed in-house based on our research. It combines the Greenblatt Magic formula with ideas developed by the father of value investing, Benjamin Graham. We called it the ERP5 screen.