Sunday, February 27, 2011

Improving Investment Returns With The Piotroski Method

When it comes to maximising investment performance, I'm a firm believer that good returns are just as much a result the of shares we don't buy as of those we do. It's easy to put a large dent in the returns from our share investments with just one poor investment decision. So with that in mind, today I'd like to discuss a way which can be used to reduce the number of poor investment decisions which we all make. It's called the Piotroski Method.

The Piotroski Method is a system devised by Joseph Piotroski (of the University of Chicago) as a way of identifying stronger companies from among a group of cheap stocks. The problem with cheap shares is that they are normally cheap for a reason. They are often in poor financial health with poor profitability and in the worst cases are at risk of insolvency.

What Piotroski found was that by avoiding the financially weak cheap shares and concentrating on the financially strong ones, investors could expect higher average investment returns.

When we talk about cheap shares, we mean those which are trading at low price to book ratios (current share price divided by net asset value per share). It's a value investor's bread and butter - sifting through shares which are trading at less than the what the company could (theoretically) be broken up and sold for. But there are many value-traps for the unwary. These companies may be teetering on the edge of bankruptcy or their industry may be in structural decline or ... well, you get the idea.

The beauty of the Piotroski Method is that using a set of signals, you are able to rate a company - give it a score (F_SCORE) based on an objective study of the firm's financial statements. This score, out of 9, tells us what sort of financial shape the company is in. The higher the score, the better. He found that companies scoring an 8 or a 9 gave the best overall average returns.

What follows are each of the criteria or 'signals' which, when added together make up a firm's F_SCORE.

1. Net Profit

Is the company profitable?

Award 1 point if the company made a profit last year.

2. Operating Cash Flow

Is the company able to generate positive cash flow through its operations?

Award 1 point if last year's operating cash flow was positive.

3. Increasing Return On Assets

Is the company becoming more profitable? Is it using its resources more efficiently?

Award 1 point of last year's return on assets was greater than that of the year before.

4. Earnings Quality

We want to make sure a company really is making as much money as it claims and in this department, cash is king. We want to see operating cash flow at least as great as net profit. Otherwise this might highlight accounting irregularities.

Award 1 point if last year's operating cash flow was greater than net profit.

5. Long Term Debt Compared To Assets

We want an in investment where the debt is under control. We are looking for a signal that financial risk is decreasing.

Award 1 point if the ratio of long term debt to assets is less than the previous year's.

6. Improving Current Ratio

Another measure of financial risk. Again we are looking for good news in that the ratio is moving in the right direction.

Award 1 point if the current ratio is greater last year than in the one before.

7. Number Of Shares Outstanding

Does the company need to raise capital to support itself? We want a company which can fund itself internally rather than one which needs to undertake capital raising's to fund 'growth'.

Award 1 point if the number of shares outstanding last year was the same as or less than the figure for the year before.

8. Improving Gross Margin

An increasing gross margin is good news. It means the company has improved its pricing power or reduced its input costs (or both).

Award 1 point if the company has increased its gross margin year on year.

9. Increasing Asset Turnover Ratio

The asset turnover ratio provides some insight into how productive a company is with its assets. A higher ratio indicates improvement in how efficiently the company is operating.

Award 1 point if the asset turnover has increased last year when compared to the year before.

If you want to look into the nitty gritty of the research done by Piotroski then you can read more about it in his research paper - http://www.chicagobooth.edu/faculty/selectedpapers/sp84.pdf.

I should warn you that it is fairly heavy going, but I think it is well worth at least skimming through the research paper. A number of important points from the research struck me.

Piotroski found the out-performance of high F_SCORE stocks over low F_SCORE stocks was greatest among smaller stocks. He also found that the out-performance was inversely correlated with the level of analyst coverage. In other words there was more money to be made in shares which were not closely followed by security analysts.

Out-performance was greatest in the 12 months immediately after formation of the portfolio. It seems that the inefficiencies in pricing don't last terribly long.

In the conclusion, Piotroski points out that he has not necessarily found the optimal set of financial ratios for use in predicting the future performance of value shares. Rather, he has shown that by using historical information to avoid financially weak companies and concentrate of strong ones, investors are able to increase average returns substantially.

It's worth stressing that his research focused on 'value stocks' or high Book to Market stocks (ie. low Price to Book).


Sunday, February 20, 2011

Best Dividend Paying Shares - The Small Caps

It's time for another 'best dividend stocks' type of post. Last time, in Highest Dividend Paying Stocks In The ASX100, I did just as the title suggests. I scoured the ASX100 looking for shares with the best income potential. While I stressed in that article that more investigative work would need to be done to whittle the list down to a handful of suitable investment candidates, I found the exercise useful and so did a number of readers.

Today's top dividend shares are all small caps. I have used the stocks which make up the S&P ASX Small Ordinaries index as a place to start my search. So based on historic dividend yield alone, I came up with the following list.

ASX Code Company Name Current Price Dividend Yield Franking Payout Ratio
TSI Transfield Services Infrastructure Fund $0.59 15.4% 0% 194%
COF Coffey International Ltd $0.84 14.1% 100% 102%
CIF Challenger Infrastructure Fund $1.18 11.9% 0% 135%
APZ Aspen Group $0.46 9.3% 0% 84%
ENV Envestra Ltd $0.60 9.2% 55% 203%
SPN SP AUSNET (stapled) $0.89 9.1% 40% 99%
CDI Challenger Diversified Property Group $0.51 8.1% 0% 72%
PMV Premier Investments Ltd $6.04 7.6% 100% 158%
AAD Ardent Leisure Ltd $1.39 7.6% 0% 94%
HST Hastie Group $0.93 7.5% 100% 54%

Best Small Cap Dividend Yields

With the top 3 companies on this list each sporting a dividend yield over 10%, these results look very impressive. However, as I did last time, I will now make a small adjustment and include only those companies with a payout ratio of 100% or less.

The purpose of this adjustment is to remove those companies whose dividend yield is not likely to be sustainable. A company can't pay out more than 100% of profits for very long. The most likely future for such a company is almost certainly one in which a lower dividend is paid.

Here is the adjusted list.

ASX Code Company Name Current Price Dividend Yield Franking Payout Ratio
APZ Aspen Group $0.46 9.3% 0% 84%
SPN SP AUSNET (stapled) $0.89 9.1% 40% 99%
CDI Challenger Diversified Property Group $0.51 8.1% 0% 72%
AAD Ardent Leisure Ltd $1.39 7.6% 0% 94%
HST Hastie Group $0.93 7.5% 100% 54%
WTP Watpac Limited $1.71 6.9% 100% 71%
SLM Salmat Ltd $4.16 6.9% 100% 79%
BWP Bunnings Warehouse Prop Trust $1.82 6.8% 0% 100%
ALZ Australand Property Group $3.10 6.7% 0% 93%
GUD GUD Hldgs Ltd $9.73 6.5% 100% 81%

Highest Sustainable Dividend Yields

The dividend yields in this list are certainly lower, but with returns ranging from 6.5% up to 9.3% (with the prospect of some capital growth thrown in), this list is certainly worthy of closer inspection.

After doing just that, I noticed that the list is somewhat overweight in property trusts or REITs (Real Estate Investment Trusts) as they are more properly called.

Now I don't have anything against property trusts. They have offered very good income prospects to investors in the past (subject to some hiccoughs during the GFC). However, when conducting my investment activities I consider these to be a separate asset class. For that reason I will filter these out from the list as well.

ASX Code Company Name Current Price Dividend Yield Franking Payout Ratio
SPN SP AUSNET (stapled) $0.89 9.1% 40% 99%
HST Hastie Group $0.93 7.5% 100% 54%
WTP Watpac Limited $1.71 6.9% 100% 71%
SLM Salmat Ltd $4.16 6.9% 100% 79%
ALZ Australand Property Group $3.10 6.7% 0% 93%
GUD GUD Hldgs Ltd $9.73 6.5% 100% 81%
HIL Hills Holdings Limited $1.87 6.0% 100% 75%
CAB Cabcharge Australia Ltd $5.84 6.0% 100% 71%
SGT Singapore Telecommunications Ltd $2.31 5.9% 0% 58%
MCP McPhersons Ltd $3.39 5.9% 100% 54%

Best Income Shares (excluding REITs)

Now we're getting somewhere. The final list has a number of good investment candidates. They all have good income potential with dividend yields of 5.9% and greater. They are a diverse group of companies across a number of unrelated industies. Seven of the ten companies pay fully franked dividends, while the eighth is franked to 40%. What's not to like?

Well for one thing, there's debt. I know that one one the companies in the list above (Hastie Group) ran into troubles with its lenders just last week and is looking like it might need to undertake a capital raising (a sure way to cut its dividend yield).

I have not applied any filters to the list for things like debt levels or financial performance (ROE, and the like). Come on - I'm not going to do all of the work for you!

I would suggest to next step would be to drill down into the financial statements of each of these companies to make sure there are no nasty surprises waiting for the unwary.

Once again I would like to stress that I am not recommending that you invest in any of the shares listed here (let Hastie group be a warning to you). The analysis above has been superficial at best, focusing on stocks with the best dividend yield. But it does give us a short list upon which we can concentrate our efforts.