Are stocks selected using Greenblatt's "Magic Formula" also stocks which are rated as "safe", according to Altman's Z-score credit rating method? As it turns out, these two groups of stocks overlap considerably, allowing investors to purchase stocks that meet the criteria of both metrics.
Quantitative Stock Screens
Why focus on stock selection using quantitative methods such as credit scoring or the "Magic Formula" at all?
Quantitative stock screens are easier to validate or dismiss empirically, allowing investors to replace belief with evidence for an investment strategy. They are easily tested because they employ standardized (repeatable) criteria and produce large numbers of picks (large sample sizes). In contrast, individualized stock recommendations are often too unique or peculiar to a particular stock and historical context, or they rely on an investor's opinion or life-experience, and/or fixate on a small number of stocks.
Even better, the attributes of quantitative screens which make them testable also make them actionable for all investors. Quantitative stock screens are potentially useful because they do not rely on investor personality or skill, and typically produce lists of investment candidates large enough to form the basis of diversified portfolios. Screening recipes can be learned or communicated, skill or luck cannot. Moreover, a diversified list of many stocks is a more prudent portfolio than a handful of qualitative stock picks.
That being said, quantitative methods can be developed that are complete hokum. In much the same way that enough monkeys banging on typewriters will produce Shakespeare, enough researchers testing different quantitative screens will produce ones that fit historical data. The least dubious quantitative screens are ones that have worked the longest across disparate markets and timeframes, and continue to work with out-of-sample data. The value effect (how low price-to-book ratio firms outperform the broader market), the Altman Z-score, and Greenblatt's "Magic Formula" have all been published and continue to function post-publication.
Do their Stock Picks Overlap?
Yes! Altman Z-scores were calculated for a sample of 74 stocks picked by the Magic Formula over the past four months and for a sample of 1844 U.S. non-financial stocks. (The Altman Z-score does not apply to financial stocks.) A higher fraction of stocks that are selected by Greenblatt's Magic Formula qualify as "safe" based on the Altman Z-score than is found in the broader U.S. stock market:
US Stocks and Magic Formula Stock Risk Classes
Magic Formula Stocks
US Stocks (Non-Financials)
This result shows how using both quantitative filters might be useful to investors. The screens are not mutually exclusive nor are they exactly aligned.
Which Stocks Made the Cut?
There are many stocks that meet the criteria of both screens:
4 Months of Magic Formula Picks With "Safe" Scores
LHC Group, Inc.
Par Pharmaceutical Companies Inc.
Tessera Technologies Inc.
China North East Petroleum Holdings
USA Mobility, Inc.
Amtech Systems Inc.
Momenta Pharmaceuticals Inc.
Career Education Corp.
LML Payment Systems Inc.
ITT Educational Services Inc.
Kulicke & Soffa Industries Inc.
Entropic Communications, Inc.
Almost Family Inc.
Forest Laboratories Inc.
PDL BioPharma, Inc.
Applied Materials Inc.
Lam Research Corporation
ManTech International Corporation
Northrop Grumman Corporation
STR Holdings, Inc.
USANA Health Sciences Inc.
Vaalco Energy Inc.
Wayside Technology Group, Inc.
Capella Education Co.
AVEO Pharmaceuticals, Inc.
Strayer Education Inc.
H&R Block, Inc.
Dolby Laboratories, Inc.
Providence Service Corp.
Metropolitan Health Networks Inc.
PetMed Express Inc.
Apollo Group Inc.
Mediware Information Systems Inc.
Comtech Telecommunications Corp.
Medicis Pharmaceutical Corp.
Cumberland Pharmaceuticals, Inc.
MIPS Technologies Inc.
Investors could use this as a shopping list to create a value portfolio.
In future articles qualitative, stock-specific reports for firms like these will be provided. These articles will kick the tires of these quantitative screens and provide color for investors who might want to know how scary some of these investments are. However, analysis peculiar to each stock will serve as a qualitative overlay and not a refutation quantitative screens or a diversified portfolio of many stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Please read the article disclaimer.