Piotroski JSE Performance

As we saw from the previous post, the theory is you only apply the Piotroski scoring methodology to "undervalued" stocks with low price-to-net-asset-values (Price:NAV). The theory goes that the growth of these "distressed" stocks in the medium term (5 years) is closely correlated to the Piotroski "F" scores they achieved at the start of the assessment period.

PowerStocks put this to the test on the JSE, ranking the 5 year average growth of stocks together with their Piotroski "F" scores as at 28 April 2003 (trough of the last big bear market). We performed the tests with all JSE shares listed at that time and then only on those shares with Price:Book ratios of less than 1. The results are shown below:


The results are rather remarkable, confirming Piotroskis' theory for the JSE. Note how Piotroski is a great bear market screen for ANY stocks (shown by the blue bars) but worked especially well for "undervalued" stocks (shown by the red bars) when F>6. Note how portfolios of shares selected with F>6 significantly outperformed the ALSI and the group average growths.

Note how the average growth of the group P2Bk<=1 is much larger than the average growth of the entire group (All), confirming the theory we postulated that undervalued share portfolios are much more likely to outperform coming out of bear markets than other stocks (See Price-to-Book : An all-time classic)

We can state that historically, Piotroski "F" scores greater than or equal to 7 for "undervalued" shares showed significant out-performance to the group average (of undervalued stocks) and the all-share index (ALSI). It also showed a lesser but still significant out-performance for all stocks regardless of their price:book ratios.

The most important observation we can make here is that even though Price:Book has been shown to be a stong, safe selection criteria for potential growth stocks, Price:Book coupled with the Piotroski valuation significantly enhances portfolio performance. The almost 1,200% performance of the portfolio of "undervalued" shares with F greater than or equal to eight is double the group average of undervalued stocks (588%) and triple the growth of the market-cap based ALSI index (350%).

NEW : The Piotroski screen is our top performing portfolio we track on the JSE since 20 Nov 2008. You can view its performance coming out of the 2008 JSE crash over here.

NEXT : Piotroski JSE Candidates

Piotroski U.S Performance

The Piotroski method is currently the 3rd most successful value investing system, tracked monthly for the last 10 years by the American Association for Individual Investors (AAII). Over the last 10 years it showed 1,069% return, versus O'Neils CANSLIM (1,489%) and the Zweig method (1,800%).

CANSLIM and Zweig are however BULL MARKET investment strategies, and Piotroski is the only BEAR MARKET screen tracked by the AAII. Since we are in the throes of the 2nd largest bear market in 20 years on the JSE, we are very interested in Piotroski's methods!



Note how the Piotroski screen massively boosts the performance of low PB stocks. And look at how the Piotroski growth exploded from the trough of the 2003 bear and remarkably is showing 20% growth in 2008 when just about everything else is lying on the floor!

But how should we explain the poor performance of Piotroski's method in the mad bull run of 2006 and 2007 and its good performance in the current crash? Quite simply, in the peak of a bull run, everyone is chasing hyped up stocks and not the low PB stocks and in the bear run everyone comes down to the level of the low PB stocks and their value coupled with their sound "financials" from the "F"-Score starts shining through.

Given the current state of the markets now, it looks like a fine time to build up a Piotroski Portfolio! Here at PowerStocks we are going to do just that, building the first EVER published Piotroski Portfolio for the JSE, right in the midst of the 2nd largest JSE fall in 20 years. But first we need to test it to see if it works on the JSE. Sure, there is a 90% chance it should but at PowerStocks we like to back test our theories on the JSE first.

NEXT : Piotroski performance on the JSE

Introduction to Piotroski

Our previous writings showed how the trend in overseas markets for low price-to-book (PB) "value" stock portfolios to outperform high PB value portfolios was spectacularly confirmed on the JSE.

It has also been shown that large portfolios of low PB stocks outperform smaller portfolios, because in general, a few stocks in the low PB portfolio have to perform spectacularly, to make up for all the losses of the other stocks in the portfolio.

This is because many low PB stocks are low for a reason and as the lowest PB stocks are generally distressed, very few of them manage to claw out of the hole they are in. Having said that, our previous PB analysis on the JSE showed that very few low PB stocks (not more than 15%) "crashed and burned" and had you put together a portfolio in May 2003 of 10 or more low PB stocks you would have done rather nicely, especially if they had PE's between 2-4.

Nevertheless, it would be nice to apply some sort of financial "evaluation" to low PB stocks to further screen out "weaker" issues and focus on those most likely to have strong financial fundamentals turn in their favour in the short term, further accelerating their over performance of the ALSI, and allowing us to get good performance by only having to manage smaller less risky portfolios.

One particular person came up with such a methodology that is quite successful. He is Joseph Piotroski and he is a professor at the University of Chicago. His paper, “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”, available as a PDF here, was published in 2000. In that paper, Piotroski showed that by using a set of nine different fundamental signals taken straight from the companies financials, to screen among low P/B stocks, an investor could separate the winners from the losers. By buying only those stocks that had the highest scores, an investor could have outperformed the market by an average of 10% per year from 1976 to 1996.

Piotroski started by screening for the stocks with the lowest P/B ratios that were non-negative. This limits the strategy to true value companies. After the price to book ratio, nine other pieces of information were used, as follows:

1. positive earnings
2. positive cash flow from operations
3. increasing ROA
4. quality of earnings : operating cashflow > net income
5. decreasing long-term debt as a proportion of total assets
6. increasing current ratio, indicating increasing ability to pay off short-term debts
7. decreasing or stable number of shares outstanding
8. increasing asset turnover ratio, indicating increasing sales as a proportion of total assets
9. increasing gross margin

Each company is given either a one or a zero on each variable to create an "F"-Score ranging from 0 to 9. The strategy calls for buying every company with the requisite low P/B ratio and a "F"-score of eight or nine. As Piotroski's research shows, low P/B stocks with high rankings are less likely to go bankrupt or to fall drastically in price than are those with low rankings, so this further adds to our defensive value picking investment strategy.

NEXT : Piotroski U.S Performance

PowerStocks PriceFinder

If we were to combine our PE criteria with the Price:Book criteria we should be getting close to a fairly powerful value-based stock selection system. Our "PriceFinder" has the two criteria that have individually shown to statistically, on average, significantly outperform the ALSI. Here we will find stocks that have P/E between 2 and 6 AND are trading at less than book (net asset) value. We also only look at stocks that trade on average more than twice a day.

It is important to note that the PriceFinder merely seeks out stocks that are available at highly reasonable fundamental valuations based on Price, Earnings, and Book Value and have a maximum probability of market outperformance based on the historical statistical groupings of these values. These are by no means the only stocks likely to outperform the ALSI and indeed the PriceFinder selection method has no bearing on the stocks' financial soundness or business prospects.

In the trough of the 2003 crash, we found 111 stocks with a Price:Book less than 1, averaging 585% growth in the subsequent 5 year period. We also found 39 stocks trading more than twice a day and with a PE between 2 and 6, averaging 508% growth in the subsequent 5 years. Combining the two criteria however, only yielded 11 stocks averaging 741% growth in the subsequent 5 years. Combining the criteria significantly narrowed the field and boosted the subsequent average growth of the portfolio.

We bet you are just itching to see what stocks on the JSE currently meet these criteria right? Below is the list of 19 JSE shares as at 29 October 2008 meeting all three criteria for the PriceFinder (PE, Price:Book and at least three trades a day). Click on the image for a larger view.


Remember that some or most of these stocks will be "obscure", since the selection criteria are typically those of "neglected or overlooked" stocks (but which we have determined, hold incredible value).

NEXT UP : Introduction to Piotroski

Price:Book - JSE Candidates

As of 29 October 2008, over 170 (or 40%) of the JSE's 426 ordinary shares are trading at less than or equal to book value. But only 90 of these are "liquid" enough for our consideration (trade more than 3 times a day on average). Of these 90 stocks, only 27 are trading at half their asset value.

Since we showed in the previous blog entry that historically the last JSE crash showed that these types of stocks significantly outperformed the rest of the market, we are now quite interested in seeing who those stocks are today. We present them below (click for bigger view)



NEXT UP : One-two combo - The PowerStocks PriceFinder

Price:Book:An all time classic

We now progress onto one of the most important fundamental metrics on the stock markets. Benjamin Graham and Warren Buffet say above all else that the Price-to-Book (or Price to Net Asset Value) ratio is one sure way to pick "cheap" defensive stocks. Note there is a difference between "cheap" and "value". Value is "Cheap" + "Fundamentally sound", so using the Price:Book is just a way to get a list of properly or under-priced candidates that will warrant further investigation of solid financials, management, etc.

This ratio is simply the market capitalisation on the day divided by its total assets minus its liabilities. It is representative of what the company were worth should it be liquidated. Why should we start with this indicator when building a stock portfolio? From page 9 of Grahams' all time 30 year classic "The Intelligent Investor" he quotes "Strangely enough, we shall suggest as one of our chief requirements that our readers limit themselves to issues selling not far above their tangible-asset value".

The book goes on to state that "The reason for this seemingly outmoded counsel is both practical and psychological. Experience has taught us that, while there are many good growth companies worth several times net assets, the buyer of such shares will be too dependant on the vagaries and fluctuations of the the stock market. By contrast, the investor in sound businesses selling at slightly above asset value can always consider themselves owners of of an interest in sound and expanding businesses, acquired at rational prices - regardless of what the stock market may say to the contrary."

But in market crashes such as the one we are currently in, the Price:Book ratio becomes even more important a selector. This is because markets tend to over-react (both on the up and on the down) and when panic ensues, prices have the tendency to go way below fair value. Graham said that stocks selected with low Price:Book ratios in a crash can form very defensive stocks, since the underlying value of the stock is far higher than what you paid for it. Over time, after one or two interims or finals, the market will quickly realise this and the stock will rise accordingly.

Just about every value investment book mentions this, but nobody has ever tested this theory on the JSE. We set out to do just that and we proudly display the results below.



Sure enough, we are presented with an astounding vilification on the JSE of Grahams sage advice. There is a remarkably clear and distinct correlation between low Price:Book ratios at the trough of a bear market, and their ability to outperform the rest of the market in the ensuing 5 years. We can look at the above graph and state that historically, Price:book ratios of less than 1 will significantly outperform those with a value greater than 1, with spectacular out performance demonstrated by issues worth less than 50% of net asset value.

NEXT UP : Book Value JSE Candidates

PE Ratio Candidates

So we saw in the trough of the last bear market, that those stocks that exhibited PE ratios of between 2 and 4 significantly outperformed all other stocks on average for the 5 year growth period that followed. Assuming we are at or close to the "trough" of the current bear market (and the ALSH PE would seem to indicate that), which JSE stocks currently exhibit this trait?


Whilst it is not safe to use this trait alone in a investment descision, as we will show a far more powerful and accurate system later on, let's satify our curiosity. As at 29 Oct 2008 here are the 29 JSE stocks out of 430 in total that exhibit PE's of between 2 and 4 and trade more than 3 times a day (click on image for details)

NEXT UP : Book value or Net Asset Value

Introduction to PE Ratio

The PE is a valuation ratio of a company's current share price compared to its per-share earnings. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per Rand of earnings. Made popular by the late Benjamin Graham, who was dubbed the "Father of Value Investing" as well as Warren Buffett's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis. A low PE indicates value and conversely a high PE indicates "expensive".

Another great investor, Martin Zweig commented : "The data going all the way back to the 1930s show conclusively that stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the longer term". Zweig's view was that although stocks with high PE's have been known to perform well, when these stocks miss forecasted earnings they get punished much worse than lower PE stocks and thus he would avoid them altogether. However Zweig also avoided stocks with "too low" PE's as he considered that something must be fundamentally wrong for these stocks to warrant such PE's.

Of course, a low PE may indicate a "cheap" share but it will not necessarily indicate a "good quality" or "value" share. Generally speaking, PE ratios of stocks need to be compared to those of stocks in similar industries, however for the purposes of the PowerStocks PE study, since we assume the stocks to be all "depressed" or heavily sold off we will be simply seeking to correlate the growth of all shares related to their PE's reported during the end of the bear cycle.

The graph below shows the growth achieved by JSE stocks since the trough of the last big JSE bear market, relative to their trailing PE's as at 28 April 2003. Note that only 136 stocks that averaged more than 3 trades a day during the month of April 2003 were considered (98 stocks were considered not liquid enough)



Sure enough we find a strong correlation between PE and share price growth. More significantly, those stocks with PE's between 2-4 significantly outperformed the ALSI (All share Index) as well as all the other PE groupings. True to Zweigs affirmations, those PE's that were "very low" significantly underperformed the market.

There were 11 stocks with PE ranging from 2 to 4 and 28 stocks ranging from PE of 4 to 6, making altogether 39 stocks with a PE betweeen 2 and 6 which averaged 508% growth. As a general observation we can safely state that historically, stocks with PE's between 2 and 6 outperformed all other stocks.

NEXT UP : PE Ratio JSE Candidates

PowerStocks Methodology

We will compare shares from the JSE ALSH ORD stock set to see how they have grown since the bottom of the last significant bear market in May 2003 to the peak of the last bull market in May 2008 (click on attached graphic for a detailed view.)



We will compare the growth rates of each stock over the 5 year ("A" to "B") period to key fundamental "value" indicators/ratios of each stock at the bottom ("A") of the last bear market. We will look at P/E, PEG, Price/NAV, Debt Ratios, Earnings growth etc.

We will then try to determine any correlation between these indicators/ratios and extent of growth achieved to finally derive a model for selecting (screening) value stocks most likely to achieve superior growth from point "C" onwards. Only "tradeable" stocks are considered that have at least 3 trades executed per day. There are about 100 stocks on the JSE that do not meet this criteria and we will not consider them since they are hard to trade and equally hard to liquidate to realise a profit.

We will also evaluate some famous "Score based" systems such as the Piotroski "F" Score system used to select stocks most likely to survive bear markets, and their effectiveness in predicting the stocks that showed superior growth since the last bear market. We will publish the first ever Piotroski ranking system of the JSE.

Finally we will use combinations of the above to present the first ever JSE fundamentals-based stock screening, ranking and scoring system that investors can use to select robust, powerful stocks most likely to outperform the market in the next bull run. Using our screening methodology in the last big bear market we would have picked 6 stocks that eventually grew in excess of 1,000 percent on average as opposed to the ALSI growth of 350%.

All of the above three objectives have not been done on the JSE and/or published for the general South African public before.

NEXT UP : Introduction to the PE Ratio

Bulls and Bears of the past

You can click on the above diagram for a more detailed view of the all-share index in the last 20 years. Note how short the "crashes" are (no more than a year but mostly less than 120 days) and how long some of the "bull runs" can be (2, 3 even 5 years!). Also note how each bull run more than makes up for the losses of the previous "bear run". Also note that as we move to the right each correction seems "deeper"misleading you into thinking the corrections are getting worse and worse but in reality as you can see from the % figures, they are all more or less the same (20-45%). This is merely an optical illusion since each correction is off a much higher base.

Undoubtedly, the last bull run has been remarkable and it is with a sigh of relief that sanity prevailed and we have a long overdue correction. The current correction is the 2nd biggest in 20 years at 45% but it has only retraced 2 years of growth (13 June 2006) and could retrace further to 50% (the 17,000 mark) or even to 16,500. When that happens you want to be ready to pile back in and make sure you are piling back into the the right PowerStocks.

We cannot say how long stocks will languish at these levels, nor how quickly they will rise again, but this is academic to the value long term investor. The idea is to get in when solid stocks are cheap and let earnings growth take care of the rest. We may never see the bull run of the last 5 years again, more likely we will see a slower more cautious and sane ride back to the top. The main point is that by getting a portfolio of the right PowerStocks together you will still be set to reap more than satisfactory returns that will outperform most of the market.

NEXT UP : The PowerStocks Methodology

A History of JSE Bear Markets

Our first lesson is an important one. You need to understand that the current bear market is normal. In fact it is welcomed for the wily investor. To quote Warren Buffet "Be scared when everyone is greedy and be greedy when everyone is scared". Now think of this - the US markets have seen their greatest drops since the great depression and Buffet has started buying American stocks!



Look at the chart above of 11 significant downturns on the JSE over the last 21 years. There have been many more "mini bears" but the ones above are the grown-up bears. Grown up bears last longer than 90 days and represent a decline of more than 15%. The periods above are the only times this has happened. Each time the market bottoms-out, it has risen to higher than all the periods before! These are normal cycles that flush the system as contrary to popular belief the markets are not that efficient. Markets either price things to high due to over exuberance, which leads to collapses and then the subsequent collapses go completely overboard in the ensuing panic. All the investment greats recognised this as golden opportunities for buying stocks for far less than they are worth and selling them for far more than they are worth. How else do you think these men made billions of dollars?

Back to the chart - you will note that we are 154 days into the current downturn and the JSE ALSH is at 18,100 (a record 44.5% down!) Yummy - this looks like the time to pack our rifles and doing some hunting! But before we willy-nilly buy any old stocks (which will lead you to fail) we need to take you through a few more lessons based on our research of the last 18 months. After all, a market is a tide upon which all boats float when it rises, but not all stocks are likely to recover from the downturn and will be smashed against the rocks as the tides drop, never to float again. With JSE PowerStocks there is a detailed and thorough process that needs to be followed to pick those Phoenixes that will rise again from the ashes.

NEXT UP : Bulls and Bears of the Past

Our Philosophy

We subscribe to the time tested value investing methodologies of the industry greats, such as Warren Buffet, Benjamin Graham and William J O'Neil and research their works extensively. We then use unique methodologies and automated research systems to track various data on the JSE and turn that into unique never before seen information that allows you to subscribe to "Value investing" principles pioneered by these great men.

Our methodologies focus on being active in large bear markets to seek out stocks of companies that are financially powerful, well run, leaders in their segments, resilient in the face of downturns and above all properly valued or even undervalued. These stocks will exhibit superior growth during and after the downturn and will exhibit large "buffers of safety" after being purchased to make your investment virtually indestructible.

These are the South African PowerStocks - rock solid, powerful and virtually guaranteed to significantly outperform the market over a period of 3-5 years, and best of all going for a song. We will demonstrate the use of quantitative analysis, never before seen in South Africa to compare stocks for selection. In short the methods we will introduce are completely new to South Africa and are going to rivet you to your seat and your screen.

To be clear, we are not speculators nor financial advisers. We merely offer you unique never before seen tools and analysis tailored for investment on the JSE and ALT-X. We built these methodologies and tools out of necessity for ourselves, since although most of them may exist for the US markets and investment public, nothing like it is available for the South African public.

NEXT UP : A history of JSE Bear Markets

About PowerStocks Research

Welcome to our first blog post. PowerStocks is a group of private investors who conduct unique research for their own private investment purposes. Through this blog we will share some of the results of the unique research methods we use for the general investing public. We feel the current financial crises offers a once-in-20 years opportunity for ordinary investors to get into the stock market at never before seen prices and set themselves up tidy nest-eggs for the future.

The research methods we use are usually the preserve of large investments funds and private client wealth managers coupled with some very unique and new concepts to South Africa. Some of our more detailed groundbreaking research will be made available for purchase from time to time, however the free information we offer will still be eye-popping, highly educational and very topical.

Enjoy, and happy hunting!

NEXT UP : Our Philosophy