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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

Sample Origin

Safe

Grey Zone

Distressed

Magic Formula Stocks

73%

15%

12%

US Stocks (Non-Financials)

54%

18%

28%

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

Ticker

Company

Altman Z-score

P/E

P/B

LHCG

LHC Group, Inc.

3.74

N/A

1.02

PRX

Par Pharmaceutical Companies Inc.

5.47

N/A

2.35

TSRA

Tessera Technologies Inc.

15.73

N/A

1.44

NEP

China North East Petroleum Holdings

3.50

2.32

0.53

USMO

USA Mobility, Inc.

3.86

2.9

1.32

ASYS

Amtech Systems Inc.

3.24

4.32

0.82

MNTA

Momenta Pharmaceuticals Inc.

36.58

4.35

2.42

PWER

Power-One Inc.

3.71

4.43

1.22

CECO

Career Education Corp.

3.25

5.12

0.84

LMLP

LML Payment Systems Inc.

5.48

5.62

1.57

ESI

ITT Educational Services Inc.

8.39

5.78

13.69

MDCO

Medicines Co.

5.28

6.18

2.16

KLIC

Kulicke & Soffa Industries Inc.

4.63

6.45

1.73

ENTR

Entropic Communications, Inc.

19.47

6.82

1.7

AFAM

Almost Family Inc.

5.04

7.5

0.84

FRX

Forest Laboratories Inc.

6.23

7.96

1.66

PDLI

PDL BioPharma, Inc.

5.19

8.55

N/A

AMAT

Applied Materials Inc.

5.24

8.6

1.85

DELL

Dell Inc.

3.50

8.64

3.46

LRCX

Lam Research Corporation

5.14

8.76

2.16

GME

GameStop Corp.

3.52

8.99

1.15

DV

DeVry, Inc.

5.55

9.04

1.96

MANT

ManTech International Corporation

3.96

9.19

1.18

TNAV

TeleNav, Inc.

6.50

9.52

1.74

NOC

Northrop Grumman Corporation

3.10

9.97

1.36

STRI

STR Holdings, Inc.

3.13

10.06

1.05

LTXC

LTX-Credence Corporation

3.64

10.14

1.5

KLAC

KLA-Tencor Corporation

6.08

10.55

2.93

USNA

USANA Health Sciences Inc.

8.70

10.66

3.16

EGY

Vaalco Energy Inc.

8.56

10.69

1.64

SNDK

SanDisk Corp.

4.04

10.69

1.88

MSFT

Microsoft Corporation

5.15

10.8

4.21

WSTG

Wayside Technology Group, Inc.

5.63

10.9

2.05

MED

Medifast Inc.

9.78

11.01

3.45

CPLA

Capella Education Co.

9.51

11.33

3.45

AVEO

AVEO Pharmaceuticals, Inc.

6.42

11.44

2.53

STRA

Strayer Education Inc.

10.49

12.18

30.95

HRB

H&R Block, Inc.

3.14

12.4

5.61

DLB

Dolby Laboratories, Inc.

13.30

12.7

2.3

PRSC

Providence Service Corp.

3.08

12.73

2.03

KFY

Korn/Ferry International

3.40

13.25

1.43

TER

Teradyne Inc.

5.19

13.56

2.17

MDF

Metropolitan Health Networks Inc.

34.44

13.77

3.85

PETS

PetMed Express Inc.

21.09

14.09

2.94

CHKE

Cherokee Inc.

7.07

14.75

8.05

APOL

Apollo Group Inc.

7.40

15.34

5.22

MEDW

Mediware Information Systems Inc.

3.92

16.09

1.9

CMTL

Comtech Telecommunications Corp.

3.67

16.21

1.18

SAI

SAIC, Inc.

2.99

17.33

1.91

NSR

NeuStar, Inc.

14.26

19.87

3.68

MRX

Medicis Pharmaceutical Corp.

3.72

20.21

2.33

VPHM

ViroPharma Inc.

4.87

20.33

2.49

CPIX

Cumberland Pharmaceuticals, Inc.

7.91

22.48

1.47

MIPS

MIPS Technologies Inc.

13.20

28.68

2.68

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.

Please read the article disclaimer.

Source: 54 'Safe' Stocks From Greenblatt's Magic Formula And Altman's Z-Score