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Subject:  It's Friday Date:  3/3/2006  11:20 AM
Author:  TwinDeltaTandem Number:  370 of 2420

Since we're into March, I'll be running numbers tomorrow looking for March buys. You're all invited to join in (it's been quiet here lately, hopefully hoopmd and I didn't scare everyone away).

On that note, I've been thinking about the criticism levied against the techniques some of us have developed for evaluating the stocks returned by MFI. It even inspired me to go back and re-read the book. Today, as well, I'm going to try and take some time to read through Piotroski's paper. My dad's a CPA who's done exceptionally well in the market, and I'm trying to get him to engage on some of these issues (he's pretty swamped with tax season right now). So the criticism hasn't fallen on deaf ears. If there are problems with some of the ideas that have been developed, I want to know what they are.

So far, this is what I think (feel free to shoot holes).

Greenblatt developed a mechanical investing scheme that is demonstrably effective at beating the market, and producing results that are "quite satisfactory." His method identifies value stocks. His book is written to demonstrate that this method can be applied blindly with very good results. However, in his book (e.g., pg. 69) as well as his lectures, he makes it clear that in applying his method you will buy bad companies if you don't go further. I'm willing to do this in order to avoid costly mistakes, and to improve on his returns (as outrageous as that may sound).

The reason MFI works is that some stocks are beaten down because the market is often irrational. For example, nothing happened this week that warrants KG being written down 20% overall. Either it was overpriced before (which is irrational) or it's underpriced now (which is irrational).

However, over the long haul, the market is efficient. Therefore, if we are to buy a stock that is underpriced (in every respect of the word) we can expect that stock to eventually be fairly priced. So we'll make money buying underpriced stock.

The problem is that the efficiency that provides our expectation of eventual fair value also drives the price of some company's stock down before we can know why. A great example of this occurred when the Challenger exploded. Nearly every NASA vendor's stock was immediately hit. However, within a day or two all but two companies had recovered. Well before the post-mortem had uncovered the actual cause of the explosion, Wall Street had identified the two vendors associated with O-Rings and had punished their stock. Creepy, huh? Likewise...some of the companies identified by MFI deserve to be cheap, and will, ipso fatso, continue to be cheap and even *depreciate* after showing up on the screen. Eventually they will disappear from MFI as their reported fundamentals catch up with their declining market value.

Break-break.

Piotroski has taken a different approach. Using the more traditional screen for value, P looks at the 20% of all companies that are cheapest in terms of price to book. So instead of screening on return of capital/earnings to stock price, P looks at stock price to physical value of the company. He then tries to resolve the problem of the market's efficiency--to determine which of these companies are cheap for irrational reasons, or at least reasons not warranted by what we know from their filings. To do so, he looks at a variety of factors designed to determine the financial health of the company.

Greenblatt's approach is simpler than P's, and performs better overall. However, it is reasonble to believe that P is doing a better job than Greenblatt at determining the financial health of the companies he returns. Whereas Greenblatt only looks at return on capital for the most recent reporting period, P is looking at a number of measures, most of which require positive trends. Greenblatt, however, still sees better results. Why?

My thesis is that Greenblatt's initial cut at the market is so much better than P's, that Greenblatt's results are better than P's even though P's overall analysis is more thorough and effective. In other words, Greenblatt is identifying value much (much) more effectively than P. P is using a value analysis which has not, as Greenblatt states in his book, been particularly valid since the period after the depression when the stock market was feared.

Greenblatt and P are doing two very different things (Greenblatt does some of what P does, but very little). Both are doing what they're doing very, very well (critics must realize that P's results are almost as good as Greenblatt's). Since P's weakness is likely due to his inferior determination of value vis-a-vis Greenblatt, it makes sense to use Greenblatt to determine value and then use Piotroski to determine financial health. This is our basic method. We've (I've) added some other steps, but these steps are just designed to reduce MFI results to a more manageable number, to reduce the number of companies I have to crunch numbers on. If there were a really easy way to do the Piotroski analysis on a large number of companies, I might propose using P on all 100 MFI returns. I just don't want to spend that much effort. (So far, the spreadsheets I've found haven't done an adequate job).

In order to whittle down the list, we've talked about two additional things to look at: the MSN stock scouter rating, and a simple analysis of EBITDA and EPS trends. Here's my take on these two...

1. Stock scouter. According to MSN, this number correlates with stock performance over the next 3-6 months, and is updated daily. It takes into account mostly financial factors, but also looks at technical analysis (which I don't like at all--I think tech analysis is counter to this entire approach) (specifically MSN looks at four areas: fundamentals, valuation, ownership and technical considerations). The rating is 1-10, with 8+ being "market outperform." I think it would be fine to buy a company that was simply "market perform," (4-7) but given that we can find companies that are 8+ within the 100 returned by MFI, I wonder why we would not want to simply stick with 8+ companies? So far, 8+ seems to correlate almost perfectly with the best performing MFI returns. However, I'm a little bit torn here. My gut tells me that anything above about a 5 is probably fine, and that 8+ might be eliminating too many gems. At any rate, this is a very quick and easy number to get--you just plug the ticker into the website. I'm definitely uneasy buying a company that is below 5, given that so many are available for purchase that rate well, and given the correlation we've seen on this board between stock value increases and MSN ratings among MFI stocks.

2. EBITDA and diluted EPS from continuing operations. These are two measures that I've been looking at since December. Greenblatt talks about the need to look at data that describes the core business as much as possible, and both of these take out extraneous factors such as one-time charges, accounting write-offs, etc. What I'm looking for here is yearly improvement over five years. For example, consider ANIK (does anyone know how to post a table???):http://moneycentral.msn.com/investor/invsub/results/statemnt.asp?Symbol=anik

2005 2004 2003 2002 2001
EBITDA 7.2 1.6 -2.1 -6.2 0.1
Diluted EPS from Cont. Operations 0.98 0.08 -0.31 -0.68 0.02

So here, if you can actually read the data, we see that 2001 was better than 2002; however, since 2002 both these metrics have steadily improved. I'd rather the company had been profitable this entire time, and that 2002 had been better than 2001; however, this data gives me good reason to believe that ANIK's management is good at growing sales and controlling costs (EBITDA), while managing their overall process efficiently to return a profit without diluting shareholder's equity (dil EPS, cont ops).

This, also, is very easy to check--so far, much easier than calculating the P Score. And given the choice between buying a company that's trading cheap but that has positive momentum in these two areas, and another that is managed erratically, I think I'd prefer to buy the former.

Finally, before buying any company, it is essential to read through recent company news (at least over the past 6 months) and to actually read all recent SEC filings. The verbiage in these is often more telling than anything you'll find in the press, particularly since we're often dealing with microcaps that are largely below the radar. One of the bennies of developing a more rigorous sreening process is that I'm simply incapable of reading every recent SEC filing and news story on 100 stocks.

Conclusion

Of each of these steps, I see MFI and Piotroski being the two most important (followed very closely by a review of the news and filings). To be honest, I don't know if we are enhancing Greenblatt with Piotroski or enhancing Piotroski with Greenblatt--it's probably more accurate to say that we are enhancing Piotroski with Greenblatt. That will sound like sacrilege to many, but I hope you've taken time to follow my argument.

Adding the MSN rating and a cursory look at EBITDA and EPS trends is merely a way to reduce the volume of detailed analysis that must be accomplished. I think these two brief analyses are reasonable to use and have both been demonstrated to be predictive of stock value performance against MFI returns. So why not use them?

So far, I have two nagging concerns. First of all, it has been noted by stock screening gurus that combining screens is not demonstrably superior to merely using a screen. However, are we really combining screens here? Technically, I think not. Piotroski screens on price to book, then he analyzes the financial health of the companies returned by his screen. We're using a different screen--MFI--for Piotroski's price to book screen. Then we're using Piotroski's method of analyzing the financials (note that P is an accounting prof, whereas Greenblatt is a finance/investment prof). Everyone on this board seems to agree that it is better to look at the financials before you buy, this is just a method of analyzing financials that has been proven effective for value stocks. It could be argued, however, that my technique of rejecting companies without growing EBITDA and EPS amounts to the introduction of a screen. But this could also be seen as a purely fundamental analysis. Anyway...

My second nagging concern is that by only buying healthy looking companies we probably won't buy the outrageously huge winners. This process, as outlined, will likely result in us buying relatively boring stocks (that, so far this year, are only returning, say, 25% per quarter or so...ho hum). I don't know how critical it is to have a few meteoric stocks in the MFI portfolio. In other words, if we remove all the outlyers--the really awesome stocks as well as the horrible dogs--what effect would this have on our expectation of 27% or so per year? There's simply no way to tell without just doing it.

I hope to hit a significant milestone in my portfolio one of these days, hopefully sooner than later, at which I think I could actually afford to simply buy equal amounts of 100 MFI stocks once a year. That way, I think I'd be able to afford to ignore the dogs. Until then, I think I'll continue looking for an efficient way to identify bad companies and eliminate them from the screen results.

TDT
Standing by for flaming arrows...
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