One of my favorite quantitative investment strategies is Professor Joseph Piotroski’s scoring method, which proved to beat the market for decades. Now you can view Piotroski stocks worldwide in our Piotroski F-Score Screener.
The advantage of companies trading below book value
Piotroski was particularly interested in stocks with low price to book value, which was also a favorite measure of Benjamin Graham and Warren Buffet. Book value is determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represents the value of the owners’ equity.
Usually, companies trade around or even above their book value if investors are predicting an increase in assets compares to liabilities. However, negative events in the company activity or sometimes turmoil in the industry can push a stock price below book value as investors are afraid of deterioration in the business and possible decrease in book value. Sometimes, the decrease in price is too strong making the stock deeply undervalued.
Like many others who have looked at the shares of such depressed companies, Piotroski also soon discovered that these stocks are delivering excess returns above the market when measured over a period of several years.
Which low price-to-book stocks are attractive?
Piotroski continued to look into the matter and found another interesting fact: the stocks that outperformed the market return did so with a huge gap, and they were the ones that pushed the average up, while most stocks actually yielded lower returns than the market.
Both of these conclusions are not surprising – many low price-to-book companies are value traps to deteriorating activities, thus are bad investments. However, if you isolate only the quality companies you can buy the winners that beat the market.
Piotroski found a fundamental set of criteria that would allow him to isolate these high-quality stocks out of all the low price-to-book stocks. He described the strategy in an interesting article entitled “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”.
Using his stock-picking criteria, he was able to theoretically average 23% annual gains between the years 1976 and 1996.
Piotroski’s rules to screen the winners
Piotroski starts by taking only the stocks with Price-to-Book multipliers at the lowest 20% in the market. Then, he uses a nine-point scale system to identify the stocks with solid and improving financials.
For each criterion that a stock meets it gets one point (in the case of equivalence between the present value to the previous year value, the stock receives half a point). The stocks that have been given an aggregate score of 8 or 9 are the stocks worth looking at.
Here are Piotroski’s 9-point criteria:
1. Positive Net Income: Stocks of profitable companies tend to perform better thus a stock gets 1 point if its net income before extraordinary profits or expenses in the last 12 months is positive.
2. Positive Cashflow: Unlike profits that can be adjusted by accounting tricks, cash flow is a measure of growth in real money. Thus a company with positive cash flow is truly a profitable one. So, 1 point is given to companies with positive operating cash flow in the last 12 months.
3. Increase in Return on Assets (ROA): This ratio is simply net income divided by total assets, and it’s a measure of the profitability of the business. To assure the profitability doesn’t deteriorate, a company gets 1 point if the last 12 months ROA is higher than one of the previous period.
4. High Profit Quality: Again, to avoid companies that try to improve their profits in the short term by making artificial adjustments in their Income Statement, Piotroski f score compare Cash flow from operating activities to net income. If operating cash flow is larger than net income the stock gets another point.
5. Reduction in debt: No one likes companies with increasing leverage. Thus, only companies that long-term debt-to-assets ratio is lower than a year ago gets 1 point here.
6. Increase in liquidity: The simplest measure for short term financial stability of a firm is the Current Ratio, which is calculated by current assets divided by current liabilities. If it’s greater than its value a year ago the company gets 1 point.
7. Dilution: Non-profitable companies or poorly managed ones tend to dilute their shareholders by issuing more shares to raise money instead of using their own cash flow. Therefore, only companies that have a less or equal number of shares outstanding compare to 12 months ago get a point in this criterion.
8. Improving gross margin: Improving gross margin (gross profit divided by sales) proves the company was able to increase its products’ prices or decrease manufacture costs. Thus, a company gets 1 point if the gross margin in the last 12 months is larger than the corresponding period last year.
9. Asset turnover: Asset turnover (total sales divided by the beginning period total assets) measures how well the company’s assets have generated sales. An increase in the asset turnover shows greater productivity from the same assets, thus 1 point is given to companies with assets turnover that is greater than the value a year ago.
Piotroski’s F-Score method is a great strategy for identifying high-quality companies that their shares are deeply undervalued. At the LongRunPlan we use Piotroski’s criteria to screen for the most qualified companies among the low price-to-book stocks. Our screener shows only the best Piotroski’s stocks with a score of 8 and 9 as they proved to be the most profitable ones.
You’re welcome to join hundreds of experienced and amateur investors using our Piotroski F-Score screen and boost your portfolio’s return with attractive stocks.