Magic Formula Investing
Re: Deligence, Diversity and Dilution

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By TwinDeltaTandem
July 27, 2006

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How does G go out of his way to caution against DD?

I'm in the middle of a move, and don't have the book right now. But there's a section where he talks about how many people just won't be able to stand it, and will try and go beyond the basic idea of picking randomly from the list. He basically says to go for it, but my impression is that he really doesn't think it's such a good idea. He then goes on to talk about how someone can significantly improve on their results by producing pro forma (forward looking) valuations from among the MFI screen results--by doing this, one would be able to hold onto a very small number of companies and exceed the results of a random port.

How can DD lead to a poorer pick?

I think the most likely way to screw up the results is to impose an incompatible investment philosophy. When I said that DD means many things to many people, this is what I was alluding to: one's approach to DD must be consistent within the investment strategy being employed. MFI is a value strategy, and at its core is mechanical. It has been backtested as a purely mechanical strategy, and doing it any other way makes you a test pilot; however, its premise is value.

Since it is a value strategy, if you're going to apply due diligence, you should apply a value-based form of due diligence. Classically, this means developing a ground-up valuation of the company and then applying market price ratio assumptions in order to arrive at a fair value for the stock. You'd then buy the stock if is reasonably below your risk-adjusted fair value. Since price ratios are typically based on forward looking earnings, you'd have to develop pro-forma financials. Greenblatt talks about this in the book. The problem is, none of us can probably do this. I worked in a fairly senior position at a Fortune 200 company and was charged with developing pro-forma financials for a tiny slice of the business; and for the most part, it was a complete crap shoot. To do this for an entire corporation is nearly impossible. (One aside--I really like the subscription data available on Morningstar, which provides some pretty decent fair value analysis. If you stick to large cap stocks, particularly, Morningstar might be a good resource to develop a lazy (mortal) man's valuation analysis.)

Now, I realize that what most people mean by DD is reading through all the news, maybe browsing the filings, etc. However, all this does, really, is tell you what has happened in the past. Such DD only helps you to figure out why the company is on the MFI screen in the first place--since ALL companies on the MFI screen are, by definition, distressed.

So you don't get "one up on Wall Street" by "due diligencing" the past; only the future.

So here's my point. When you do your DD and start cherry picking from the list, I think you're more likely to eliminate the stocks that will end up being really huge winners than you are to pick them. That's because these are the stocks that are going to be the most difficult to figure out. They're the ones like the small drilling company that had lost its leases in eastern Europe. It had rigs that were sitting completely idle. Hardly anyone thought the company was a buy, but within weeks it had been absorbed by a larger company that already controlled its stock. DD would have caused nearly everyone to pass, but a purchase in this company would have resulted in a huge annualized gain. Your DD might pick lots of OK stocks, it might even eliminate something that's falling out of the sky like a streamlined crowbar; but it probably won't identify the huge stars that you'll need in any mechanical port.

So where's Piotroski fit in?

The seemingly elegant thing about using Piotroski (a process of diagnosing the financial health of a company, which results in an "F_Score"; 1-3 is bad; 7-9 is good) is that Piotroski is philosophically very similar to Greenblatt. They are compatible in that both methods are dealing with value. Greenblatt admires Piotroski in his book. Piotroski, however, uses book value to define "value," and then whittles down the value universe using financial metrics to determine really bad companies that he shorts, and good companies that he buys long. Greenblatt does what Greenblatt does, but only buys long. Interestingly, you can sometimes find a company that shows up on MFI which scores such a poor F_Score that Piotroski would short it. I think that's a pretty good reason not to buy an MFI stock.

Also, Piotroski works really well on long purchases of companies that are so small they aren't covered by analysts (this makes sense, given that analysts provide pro-forma financials; in the absence of analyst coverage, there are no public pro-forma data. Therefore, we have our greatest opportunity to have an advantage against the street with companies that aren't covered). So, I think it makes good sense to buy non-covered companies that score a 7-9 on Piotroski. However, these are really nerve-racking, scary buys in that the volume is extremely low, they tend to be fairly erratic, they can get wiped out with the loss of a single major account, you can have a difficult time trading the stock, etc.

So...I just think that most of us, including myself, would be better off sticking to a very simple approach with MFI. I'm cool with eliminating low F_Score companies, maybe adding a slightly disproportionate number of high F_Score non-covered companies, etc. But I'm also very, very comfortable with simply buying all 25 companies on, say, July 24th and then ignoring the port until next year.


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