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).
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