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| The Basics | Value stocks that live up to the name
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A few stocks defined as value investments far outshine the rest. Here's how to find potential winners with a screen that adapts a proven formula.
By Harry Domash
Advocates of value investing like to point out that beaten-up value stocks outperform growth stocks over time. And they're right.
But there's a catch. The portfolios in those tests contained hundreds of stocks, but a few outlandishly successful value investments skewed the results. In fact, most stocks underperformed the market, and many disappeared altogether. The lesson in those results: Buying stocks based on valuation alone doesn't make sense for individual investors who aren't in a position to buy several hundred stocks.
The top of the barrel's bottom
Joseph Piotroski, an accounting professor at the University of Chicago, pondered this conundrum and came up with a pretty good solution. He reasoned that because value stocks are troubled companies by definition, many are financially distressed and won't have the financial resources to recover. He wondered if he could improve the performance of a value portfolio by throwing out the financially weakest stocks.
To find out, Piotroski devised a simple nine-part scoring system (see sidebar below) to evaluate financial strength using data that could be derived solely from financial statements.
Piotroski awarded one point for each test that a company passed, and he classified those scoring eight or nine points as strong stocks. He found that strong stocks outperformed a portfolio consisting of all value stocks by 7.5% annually over his 20-year test period. But there's more. Piotroski found that weak stocks (those with just one or two points) were five times more likely to delist from their stock exchanges because of financial problems.
Piotroski's report was published in 2000, and a variety of researchers have since found that portfolios constructed using his scoring system regularly outperform the market.
Improving on success
But here's the interesting part. | Piotroski's Nine Tests | Score one point if a stock passes each test and zero if it doesn't.
1) Net income: Net income is the bottom line, and Piotroski favors profitable companies. Passes if last fiscal year net income is positive.
2) Operating cash flow: Like many experts, Piotroski considers cash flow the real earnings gauge. Passes if full-year cash flow is positive.
3) Return on assets: ROA measures profitability and Piotroski wants to see increasing profitability. Passes if full-year ROA exceeds prior-year ROA.
4) Quality of earnings: Cash flow usually exceeds net income because income is typically reduced by non-cash charges such as depreciation. Many experts consider it a warning of possible accounting shenanigans if that's not the case. Passes if full-year operating cash flow exceeds net income.
5) Long-term debt vs. assets: Piotroski prefers companies that are cutting debt. Passes if the full-year ratio of long-term debt to assets is down from year-ago. The long-term debt/equity ratio is a reasonable substitute for debt/assets.
6) Current ratio: CR, the ratio of current assets to current liabilities, is a working capital measure, and Piotroski prefers increasing working capital. Passes if the CR increases from the prior year.
7) Shares outstanding: Piotroski penalizes companies that sell stock to raise cash. Passes if the current number of shares outstanding is no greater than the year-ago figure.
8) Gross margin: Increasing gross margins (profit margin based on direct production costs) often signal that a company's competitive position is improving. Passes if full-year GM exceeds the prior-year GM.
9) Asset turnover: A standard productivity measure, AT is revenues divided by total assets. Piotroski wants to see a year-over-year AT increase. You can check it by comparing the full-year sales growth to asset growth. Passes if the percentage increase in sales exceeds the percentage increase in total assets. |
Piotroski arbitrarily defined his nine tests and that was it. He spent zero time refining his scoring system. He didn't try to optimize his parameter selection and he didn't fiddle with the pass/fail values. He didn't try to improve his results by weighting certain tests more than others. So it's likely that different combinations of financial statement items would work equally well, if not better.
That is good news because it means there is nothing special about Piotroski's specific selection of financial items and values. It's his concept of isolating value-priced stocks with strong fundamentals that makes the system work, not the particulars.
That means that even though we can't exactly duplicate his tests, we can use MSN's Deluxe Screener to find stocks that conform to Piotroski's strategy.
To do it, you need to use a set of MSN's screening parameters that you may not have noticed before. They're listed in the cryptically labeled Advisor FYI category and allow you to screen for changes in items such as profitability, debt levels, growth rates and even analysts' estimates.
Here's how to screen for the fundamentals.
Finding the low price
Researchers usually use the price/book ratio to divide stocks into value and growth portfolios. Typically, they determine the median Price/Book value for all stocks and then define stocks with P/B below the median as value and those above as growth. The last time I checked, the median P/B was around 1.9. I set my maximum allowable P/B at 1.5 to insure that my candidates were well within the value definition. More than 1,800 stocks fit that requirement. Increase your maximum P/B to 1.9 if your screen doesn't turn up enough candidates.
Screening parameter: Price/Book Value <= 1.5
The bottom line
Piotroski's first test checks for positive net income. I use the net income from continuous operations parameter for that check. It ignores gains or losses from operations that have been sold or closed during the past year. It's a better measure of a company's outlook than income from total operations, which does include discontinued operations.
Screening parameter: 12-Month Income: Cont. Ops >= 0
Keep the cash flowing
Piotroski's second test requires positive operating cash flow. We can't screen for cash flow directly, so I used the Price/Cash Flow ratio, which is just as good, since the ratio can't be positive unless cash flow is positive.
Screening parameter: Price/Cash Flow Ratio >= 0
Increasing return on assets
Passing Piotroski's third test requires an increase in return on assets in the last fiscal year vs. the year before. You can use the ROA parameter located in the Profitability section of the screener's Advisor FYI category to search for increasing ROA.
The screener's labeling is misleading for this and similar search terms. The labels indicate you can specify that ROA increased during the last quarter, or the last year. But, as far as I can tell, those selections all look for increasing ROA measured over the trailing 12 months compared to the prior 12-month period. Using the last 12 months is as good, and arguably better, than comparing the last two fiscal years.
Screening parameter: Return on Assets Increased Since
Decreasing debt
Piotroski's fifth test rewards companies with decreasing debt compared to the prior year. The long-term debt/equity ratio covers that territory.
Screening parameter: Debt to Equity Ratio Decreased Since
Growing profitability
Piotroski's eighth test requires a year-over-year increase in gross profit margins. I substituted net profit margin for gross margin. Net profits consider all expenses while gross margins include only the cost of making the products without considering administrative, research and development, or marketing costs. The point of the test is to pinpoint companies with an improving profit picture, and in my view, net profit is the better gauge.
When I ran the screen for this article, it turned up 15 stocks, including two real estate investment trusts (REITs), a bank and a savings and loan. These may be good candidates but Piotroski didn't include financial stocks or REITs in his portfolios, so I deleted them. That left me with 11 candidates in a variety of industries. Five are in the tech sector, but none were in the same industry. Increase the maximum price/book ratio in the screen if you need more candidates.
| Real-value stocks | | Company | Industry | Price/Book Value | | Advanced Digital Information (ADIC, news, msgs) | Data storage devices | 1.40 | | American Biltrite (ABL, news, msgs) | Rubber & plastics | 0.84 | | Central Parking (CPC, news, msgs) | Consumer services | 1.19 | | Chiquita Brands International (CQB, news, msgs). | Farm products | 1.29 | | Computer Sciences (CSC, news, msgs) | Information technology services | 1.29 | | The Cronos Group (CRNS, news, msgs) | Rental & leasing services | 1.06 | | Hanarotelecom ADR (HANA, news, msgs) | Internet software & services | 0.66 | | Key Tronic (KTCC, news, msgs) | Computer peripherals | 1.47 | | New England Realty Association ADR (NEN, news, msgs) | Property management | 0.91 | | P & F Industries (PFIN, news, msgs) | Small tools & accessories | 1.38 | | Synnex (SNX, news, msgs) | Technical & system software | 1.32 |
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At the time of publication, Harry Domash did not own or control any of the stocks mentioned in this article.
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