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.

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