I can't find a thread like this on the forum so I decided to create it. The purpose of this thread is for myself and others to post their respective investment strategies/theories. Whether it's your own, or a strategy that you've discovered, implemented, and have liked, or even one that you hate.
I've always been interested in different investment strategies. Limiting yourself to one is a big mistake in my opinion. I'll be posting some of my favourite strategies, and some that I don't like. The point is to learn, test, and improve.
The first strategy that I'll be posting is the Piotroski High F-Score screen. It's a less-common method, and you rarely see it being used in the industry. In saying that, however, wealth management and boutique investment banking firms are beginning to use it more nowadays.
Personally, I've used this method in the past. It's fairly simple to use if you have a general understanding of accounting and financial concepts. If you don't have a general understanding of these concepts, I'll be going fairly into detail below.
Investment Strategy: The Piotroski High F-Score ScreenI've always been interested in different investment strategies. Limiting yourself to one is a big mistake in my opinion. I'll be posting some of my favourite strategies, and some that I don't like. The point is to learn, test, and improve.
The first strategy that I'll be posting is the Piotroski High F-Score screen. It's a less-common method, and you rarely see it being used in the industry. In saying that, however, wealth management and boutique investment banking firms are beginning to use it more nowadays.
Personally, I've used this method in the past. It's fairly simple to use if you have a general understanding of accounting and financial concepts. If you don't have a general understanding of these concepts, I'll be going fairly into detail below.
Numerous research studies point to the long-term success of using value strategies to select stocks. Value strategies build stock portfolios by seeking out stocks with low prices relative to variables such as; earnings, book value, cash flow or dividends.
Joseph Piotroski is an accounting professor at the University of Chicago Graduate School of Business. He recently undertook a study of low price-to-book value stocks to see if it's possible to establish some basic financial criteria to help separate winners from losers.
Low Price-to-Book-Value
Piotroski's work starts with low price-to-book-value stocks. Price-to-book-value was a favourite measure of Graham and his students who sought companies with a share price below their book value per share. While the market does a decent job of valuing securities in the long-run, in the short-run it can overreact to the information it receives and pushes prices away from their true value. Measures such as price-to-book-value help to identify which stocks are truly undervalued and neglected.
For those who are unfamiliar with investment concepts, the price-to-book-value is determined by dividing the market price by the book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represent the value of the owners' equity based upon historical accounting decisions.
If accounting really captured the current values of the firm, then it's not a stretch to imagine that the current stock price will be selling for a price near its accounting book value. However, this is not the case; many events often distort the book value figure.
For example - inflation can leave the replacement cost of capital goods within the firm far above their stated book value, or the purchase of a firm may lead to accounting goodwill (not economic which although intangible, is important). Some services are more conservative in reporting book value and may subtract out the value of intangibles such as patents, copyrights, trademarks, or goodwill. Different accounting policies among industries may also come into play when screening for low price-to-book stocks.
Piotroski first limited his universe to the bottom 20% of stocks according to their price-to-book-value ratio and this should be your first screening criterion. Valuation levels of stocks vary over time, often dramatically from bear market bottoms to bull market tops. During depths of a bear market, many firms can be found selling for a price-to-book ratio less than one. In the latter stages of a bull market, few companies other than troubled firms sell for less than book value per share.
Most stocks trade with an extremely low price-to-book value. These firms are neglected or often financially troubled. Small, thinly traded stocks are rarely followed by analysts. The flow of information is limited for these stocks and can lead to mispriced stocks. Analysts typically ignore these stocks and tend to focus on stocks with general interest.
Financially distressed firms are often beaten down below their intrinsic value as investors await strong signs that a company has fixed its problems and the worst is behind them. Poor performance = overly pessimistic expectations of future performance. This pessimistic value translates into above market performance as companies outperform market expectations in subsequent quarters.
Piotroski found either situation can create buying opportunities, after checking on financial strength, especially when studying smaller cap stocks.
Financial Conditions
Piotroski developed a 9 point scale that helps to identify stocks with solid and improving financials. Profitability, financial leverage, liquidity, and operating efficiency are examined using popular ratios and basic financial elements that are easy to use and interpret. For this screen a passing stock is required to have a score of eight or nine.
1) Minimum Profitability: Piotroski awarded up to 4 points for profitability; 1 for positive return on assets, 1 for positive cash flow from operations, one for an improvement in return on assets over the last year, and 1 if cash flow from operations exceeded net income. These are very very simple tests that are easy to measure. Don't worry about industry, market, or time-specific comparisons.
2) ROA (Return on Assets): Using this strategy, ROA is defined as net income before extraordinary items for the fiscal year preceding analysis, divided by total assets at the beginning of the fiscal year. A high ROA implies that the assets are producting and well-managed.
Piotroski didn't look for high levels; only a positive figure. While this strategy may not seem restrictive, he found that over 40% of the low price-to-book-value stocks had experienced a loss in the prior two fiscal years. Positive income is a significant event for these firms. The next variable to consider is improving profitability. 1 point should be awarded if the current year's ROA is greater than the prior year's ROA.
3) Operating Cash Flow: 1 point is awarded if a firm had positive operating cash flow (OCF). OCF is reported on the statement of cash flows and measures a company's ability to generate cash from day-to-day operations as it provides goods and services to its customers. Factors such as cash from the collection of AR, cash incurred to produce any goods and services, payments, taxes, etc...A positive cash flow from operations implies that a firm was able to generate enough cash from continuing operations without the need for additional funds. A negative cash flow from operations indicates that additional cash inflows were required.
4) Accrual Accounting Check: This examines the relationship between the earnings and cash flow. 1 point is awarded if cash from operations exceeded net income before extraordinary items. This measure tries to avoid firms making account adjustment to earnings in the short run that may weaken long-term profitability. Piotroski feels that this element may be especially important for value firms; which have a strong incentive to manage earnings to avoid violations to debt covenants.
5) Capital Structure: Up to 3 points should be awarded for capital structure and the firm's ability to meet future debt obligations. 1 point if the ratio of debt-to-total-assets declined in the past year, 1 if the current ratio improved over the past year, and 1 if the company did not issue any additional common stock. Since many low price-to-book value stocks are constrained financially, he assumed that an increase in financial leverage, a deterioration of liquidity or the use of external financing is a sign of increased financial risk.
6) Financial Leverage: This method defined debt-to-total-assets as long-term debt + the current portion of long-term debt divided by average total assets. The higher the figure, the greater the financial risk. Smart use of debt allows a company to expand operations and leverage the investment of shareholders provided that the firm can earn a higher return than the cost of debt. By raising additional external capital, a financially distressed firm is signaling that is unable to generate sufficient internal cash flow. An increase in long-term debt will place additional constraints on the financial flexibility of a firm, and will likely come at great cost.
7) Liquidity: In order to judge liquidity, a company earns 1 point if its current ratio at the end of its most recent fiscal year increased compared to the prior fiscal year. Liquidity ratios examine how easily the firm could meet its short term obligations, while financial risk ratios examine a company's ability to meet all liability obligations.
The current ratio compares the level of the most liquid assets (current assets) against that of the shortest maturity liabilities (current). Go back to accounting 101 and divide current assets by current liabilities. A high current ratio indicates a high level of liquidity and less risk of financial troubles. Too high a ratio may mean unnecessary investment in current assets or failure to collect receivables(or a bloated inventory), all negatively affecting earnings. A low ratio implies illiquidity and the potential for being unable to meet current liabilities and random shocks that may reduce the inflow of cash.
Piotroski assumed that an improvement in the current ratio is good signal regarding a company's ability to service its current debt obligations. He also indicated in a footnote that the decline in current ratio was only significant if the current ratio is near one.
8) Equity: 1 point if the firm did not issue common stocks over the last year. Similar in concept to an increase in long-term debt, financially distressed companies that raise external capital could be indicating that they are unable to generate sufficient internal cash flow to meet obligations.
9) Operating Efficiency: Now we examine changes in the efficiency of operations. 1 point for showing an increase in their gross margin, and another point if asset turnover has increased over the last fiscal year. These ratios reflect two key elements impacting ROA. Longer-term investors (I know lots on this forum are day-traders), buy shares of a company with the expectation that the company will produce a growing future stream of cash. Profits point to the company's long-term growth and staying power. Gross profit margins reflect the firm's basic pricing decisions and its material costs. This is computed by dividing gross income (sales - COGS) by sales for the same time period.
Piotroski zeroed in on improving gross profit margin because of immediate signal of an improvement in production costs, inventory costs, or increase in the sale's price of the company's product or service.
The final element in Piotroski's financial scoring system adds a point if asset turnover for the latest fiscal year is greater than the prior year's turnover.
Asset turnover (total sales divided by beginning period total assets) measures how well the company's assets have generated sales. Industries differ dramatically in asset turnover, so comparison to firms in similar industries is crucial. Too high a ratio relative to other firms may indicate insufficient assets for future growth and sales generation, while too low an asset turnover figure points to redundant or low productivity assets. An increase in the asset turnover signifies greater productivity from the asset base and possibly greater sales levels.
Conclusion
I've attached a chart showcasing the results (I couldn't find 2015/2016, so if anyone can, please post below!). The screening results tie low price to book to a perfect score of 8 or 9. Overall, Piotroski found that the higher the financial score, the higher the average portfolio return. Overall, the higher the financial score the greater the average portfolio return. Results of individual stock will vary dramatically. Even with these additional financial tests it is important to perform a careful analysis of any passing stocks.
![[Image: Untitled.png]](http://s23.postimg.org/8hwzm6tqz/Untitled.png)
Summary
Piotroski: High F-Score Screening Criteria
The stock must satisfy at least eight of the following nine parameters:
- The return on assets for the last fiscal year (Y1) is positive
- Cash from operations for the last fiscal year (Y1) is positive
- The return on assets ratio for the last fiscal year (Y1) is greater than the return on assets ratio for the fiscal year two years ago (Y2)
- Cash from operations for the last fiscal year (Y1) is greater than income after taxes for the last fiscal year (Y1)
- The long-term debt to assets ratio for the last fiscal year (Y1) is less than the long-term debt to assets ratio for the fiscal year two years ago (Y2)
- The current ratio for the last fiscal year (Y1) is greater than the current ratio for the fiscal year two years ago (Y2)
- The average shares outstanding for the last fiscal year (Y1) is less than or equal to the average number of shares outstanding for the fiscal year two years ago (Y2)
- The gross margin for the last fiscal year (Y1) is greater than the gross margin for the fiscal year two years ago (Y2)
- The asset turnover for the last fiscal year (Y1) is greater than the asset turnover for the fiscal year two years ago (Y2)
Joseph Piotroski is an accounting professor at the University of Chicago Graduate School of Business. He recently undertook a study of low price-to-book value stocks to see if it's possible to establish some basic financial criteria to help separate winners from losers.
Low Price-to-Book-Value
Piotroski's work starts with low price-to-book-value stocks. Price-to-book-value was a favourite measure of Graham and his students who sought companies with a share price below their book value per share. While the market does a decent job of valuing securities in the long-run, in the short-run it can overreact to the information it receives and pushes prices away from their true value. Measures such as price-to-book-value help to identify which stocks are truly undervalued and neglected.
For those who are unfamiliar with investment concepts, the price-to-book-value is determined by dividing the market price by the book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represent the value of the owners' equity based upon historical accounting decisions.
If accounting really captured the current values of the firm, then it's not a stretch to imagine that the current stock price will be selling for a price near its accounting book value. However, this is not the case; many events often distort the book value figure.
For example - inflation can leave the replacement cost of capital goods within the firm far above their stated book value, or the purchase of a firm may lead to accounting goodwill (not economic which although intangible, is important). Some services are more conservative in reporting book value and may subtract out the value of intangibles such as patents, copyrights, trademarks, or goodwill. Different accounting policies among industries may also come into play when screening for low price-to-book stocks.
Piotroski first limited his universe to the bottom 20% of stocks according to their price-to-book-value ratio and this should be your first screening criterion. Valuation levels of stocks vary over time, often dramatically from bear market bottoms to bull market tops. During depths of a bear market, many firms can be found selling for a price-to-book ratio less than one. In the latter stages of a bull market, few companies other than troubled firms sell for less than book value per share.
Most stocks trade with an extremely low price-to-book value. These firms are neglected or often financially troubled. Small, thinly traded stocks are rarely followed by analysts. The flow of information is limited for these stocks and can lead to mispriced stocks. Analysts typically ignore these stocks and tend to focus on stocks with general interest.
Financially distressed firms are often beaten down below their intrinsic value as investors await strong signs that a company has fixed its problems and the worst is behind them. Poor performance = overly pessimistic expectations of future performance. This pessimistic value translates into above market performance as companies outperform market expectations in subsequent quarters.
Piotroski found either situation can create buying opportunities, after checking on financial strength, especially when studying smaller cap stocks.
Financial Conditions
Piotroski developed a 9 point scale that helps to identify stocks with solid and improving financials. Profitability, financial leverage, liquidity, and operating efficiency are examined using popular ratios and basic financial elements that are easy to use and interpret. For this screen a passing stock is required to have a score of eight or nine.
1) Minimum Profitability: Piotroski awarded up to 4 points for profitability; 1 for positive return on assets, 1 for positive cash flow from operations, one for an improvement in return on assets over the last year, and 1 if cash flow from operations exceeded net income. These are very very simple tests that are easy to measure. Don't worry about industry, market, or time-specific comparisons.
2) ROA (Return on Assets): Using this strategy, ROA is defined as net income before extraordinary items for the fiscal year preceding analysis, divided by total assets at the beginning of the fiscal year. A high ROA implies that the assets are producting and well-managed.
Piotroski didn't look for high levels; only a positive figure. While this strategy may not seem restrictive, he found that over 40% of the low price-to-book-value stocks had experienced a loss in the prior two fiscal years. Positive income is a significant event for these firms. The next variable to consider is improving profitability. 1 point should be awarded if the current year's ROA is greater than the prior year's ROA.
3) Operating Cash Flow: 1 point is awarded if a firm had positive operating cash flow (OCF). OCF is reported on the statement of cash flows and measures a company's ability to generate cash from day-to-day operations as it provides goods and services to its customers. Factors such as cash from the collection of AR, cash incurred to produce any goods and services, payments, taxes, etc...A positive cash flow from operations implies that a firm was able to generate enough cash from continuing operations without the need for additional funds. A negative cash flow from operations indicates that additional cash inflows were required.
4) Accrual Accounting Check: This examines the relationship between the earnings and cash flow. 1 point is awarded if cash from operations exceeded net income before extraordinary items. This measure tries to avoid firms making account adjustment to earnings in the short run that may weaken long-term profitability. Piotroski feels that this element may be especially important for value firms; which have a strong incentive to manage earnings to avoid violations to debt covenants.
5) Capital Structure: Up to 3 points should be awarded for capital structure and the firm's ability to meet future debt obligations. 1 point if the ratio of debt-to-total-assets declined in the past year, 1 if the current ratio improved over the past year, and 1 if the company did not issue any additional common stock. Since many low price-to-book value stocks are constrained financially, he assumed that an increase in financial leverage, a deterioration of liquidity or the use of external financing is a sign of increased financial risk.
6) Financial Leverage: This method defined debt-to-total-assets as long-term debt + the current portion of long-term debt divided by average total assets. The higher the figure, the greater the financial risk. Smart use of debt allows a company to expand operations and leverage the investment of shareholders provided that the firm can earn a higher return than the cost of debt. By raising additional external capital, a financially distressed firm is signaling that is unable to generate sufficient internal cash flow. An increase in long-term debt will place additional constraints on the financial flexibility of a firm, and will likely come at great cost.
7) Liquidity: In order to judge liquidity, a company earns 1 point if its current ratio at the end of its most recent fiscal year increased compared to the prior fiscal year. Liquidity ratios examine how easily the firm could meet its short term obligations, while financial risk ratios examine a company's ability to meet all liability obligations.
The current ratio compares the level of the most liquid assets (current assets) against that of the shortest maturity liabilities (current). Go back to accounting 101 and divide current assets by current liabilities. A high current ratio indicates a high level of liquidity and less risk of financial troubles. Too high a ratio may mean unnecessary investment in current assets or failure to collect receivables(or a bloated inventory), all negatively affecting earnings. A low ratio implies illiquidity and the potential for being unable to meet current liabilities and random shocks that may reduce the inflow of cash.
Piotroski assumed that an improvement in the current ratio is good signal regarding a company's ability to service its current debt obligations. He also indicated in a footnote that the decline in current ratio was only significant if the current ratio is near one.
8) Equity: 1 point if the firm did not issue common stocks over the last year. Similar in concept to an increase in long-term debt, financially distressed companies that raise external capital could be indicating that they are unable to generate sufficient internal cash flow to meet obligations.
9) Operating Efficiency: Now we examine changes in the efficiency of operations. 1 point for showing an increase in their gross margin, and another point if asset turnover has increased over the last fiscal year. These ratios reflect two key elements impacting ROA. Longer-term investors (I know lots on this forum are day-traders), buy shares of a company with the expectation that the company will produce a growing future stream of cash. Profits point to the company's long-term growth and staying power. Gross profit margins reflect the firm's basic pricing decisions and its material costs. This is computed by dividing gross income (sales - COGS) by sales for the same time period.
Piotroski zeroed in on improving gross profit margin because of immediate signal of an improvement in production costs, inventory costs, or increase in the sale's price of the company's product or service.
The final element in Piotroski's financial scoring system adds a point if asset turnover for the latest fiscal year is greater than the prior year's turnover.
Asset turnover (total sales divided by beginning period total assets) measures how well the company's assets have generated sales. Industries differ dramatically in asset turnover, so comparison to firms in similar industries is crucial. Too high a ratio relative to other firms may indicate insufficient assets for future growth and sales generation, while too low an asset turnover figure points to redundant or low productivity assets. An increase in the asset turnover signifies greater productivity from the asset base and possibly greater sales levels.
Conclusion
I've attached a chart showcasing the results (I couldn't find 2015/2016, so if anyone can, please post below!). The screening results tie low price to book to a perfect score of 8 or 9. Overall, Piotroski found that the higher the financial score, the higher the average portfolio return. Overall, the higher the financial score the greater the average portfolio return. Results of individual stock will vary dramatically. Even with these additional financial tests it is important to perform a careful analysis of any passing stocks.
Summary
Piotroski: High F-Score Screening Criteria
The stock must satisfy at least eight of the following nine parameters:
- The return on assets for the last fiscal year (Y1) is positive
- Cash from operations for the last fiscal year (Y1) is positive
- The return on assets ratio for the last fiscal year (Y1) is greater than the return on assets ratio for the fiscal year two years ago (Y2)
- Cash from operations for the last fiscal year (Y1) is greater than income after taxes for the last fiscal year (Y1)
- The long-term debt to assets ratio for the last fiscal year (Y1) is less than the long-term debt to assets ratio for the fiscal year two years ago (Y2)
- The current ratio for the last fiscal year (Y1) is greater than the current ratio for the fiscal year two years ago (Y2)
- The average shares outstanding for the last fiscal year (Y1) is less than or equal to the average number of shares outstanding for the fiscal year two years ago (Y2)
- The gross margin for the last fiscal year (Y1) is greater than the gross margin for the fiscal year two years ago (Y2)
- The asset turnover for the last fiscal year (Y1) is greater than the asset turnover for the fiscal year two years ago (Y2)
