Part 2: Using the Magic Formula to Rank Piotroski Stocks
The Magic Formula is basically just a combination of two metrics: high ROE (to find highly effective companies) and low P/E (to find undervalued ones) and documented in a great book by Joel Greenblatt.
This post is the second in a series about the Piotroski stock-picking methodology and its real-life application:
- Part 1: The Underrated Piotroski Stock-Picking Methodology
- Part 2: Ranking Stocks Found via the Piotroski Filter
- Part 3: Anatomy of a Piotroski Portfolio: Buying and Selling
- Part 4: My current Piotroski results
To combine the two metrics, rank your list of stocks (possibly obtained via the excellent and totally underrated Piotroski screening method) in a separate column for each criterion, using a spreadsheet app. Then, combine both ranks with a simple addition in a third column, so you get a unified rank.
Now, having applied this ranking method to a new batch of Piotroski-filtered stocks with at least 8 in F-Score, I got what you see here as a 1 year backtest via Google Finance:
2013 has been a good year for stocks, true, but this method here got us triple the Dow Jones’ return. That is A-M-A-Z-I-N-G. The next stocks I buy for my portfolio will definitely be ranked using this method.
Even without the Piotroski method explained in this in-depth post, the Magic Formula seems to be pretty powerful, especially considering its simplicity. You should never forget to have a close look at the stocks you want to buy, though. One easy way of doing that to get a quick overview is to use the Financial Times website and search for the stock there. It allows you to easily look up the financial information with neat diagrams so you immediately see how revenues evolved over the past quarters / years, and analyst recommendations (=the least useful part).
If you don’t want to do the work required, then don’t invest in stocks, or you’ll make yourself very unhappy.
If you want to read the details of why the Magic Formula works, have a look at the book by Joel Greenblatt.