Discrimination in Selecting Net-Net Stocks - Piotroski F_Score

"(...) the phenomenon of 1932 was the direct outgrowth of the new-era doctrine which transferred all the tests  to the income account and completely ignored the balance- sheet (...)There is scarcely any doubt that common stock selling well below liquidating value represent on the whole a class of undervalued securities.... declined in price so severely than the actual conditions justify...must mean that on the whole these stocks afford profitable opportunities for purchase.(...) Nevertheless, the securities analyst should exercise as much discrmination  as possible in the choice of issues falling within this category.(...) he will be partial to such (...)reveal other attractive statistical features besides their liquid asset position, e.g. satisfactory current earnings and dividends, or a high average earning power in the past.(...)The analyst will avoid issues which have been loosing their quick assets at a rapid rate and show no definite signs of ceasing to do so."

(Source: Security Analysis 1st Edition page 498 ff.)

Recently I came across a paper by Joseph D. Piotroski called "Value Investing: The Use of Historical Financial Statement Information to Seperate Winners from Losers" (Journal of Accounting Research; Vol.38), explaining and backtesting a simple strategy how to improve the performance of a high BM (=Book to Market) Portfolio.

Unfortunately I found this paper in a rather late stage of applying a value strategy in my investment portfolio, as it is well written, is an easy concept, makes a lot of sense and (as far as I can see it) comes up with statistically relevant (stable) conclusions.

Fortunately, as his concept (strategy) was touched on by Graham and Dodd (see link), it is quite simple and it makes so much sense, I already had partially applied it to my portfolio decisions before reading it.

Selecting Cheap Stocks: Piotroski's Message

Basically the paper examines, whether a simple accounting-based fundamental analysis strategy, when applied to a broad portfolio of high book-to-market firm (= low P/B firms), can increase the overall performance compared to a portfolio only composed of high BM stocks.

The basic idea behind it is the observation, that the success of a high BM portfolio strategy relies on the strong performance of a few firms. Piotroski observed, that only 44% of all high BM firms earn positive market-adjusted returns in the two years following the portfolio formation. He was wondering if a simple set of financial ratios, laid over a high BM portfolio, could weed out the weak companies from the strong companies, and thus  investors can create a stronger value portfolio.

He argues, that the (...) differentiation of eventual "winners" from "losers" should shift the mean returns earned by a value investor (...), and statistically verifies that (...) the mean return (..) can be increased by at least 7,5% annualy through the selection of financially strong high BM firms (...)

His starting point is, that (...) numerous research papers document that investors can benefit from trading on various signals of financial performance.Furthermore he argues that (...) value stocks are inherently more conducive to financial statement analysis than growth stocks (...) most of the predictability in growth stock returns appears to be momentum driven (...) In contrast, the valuation of value stocks should focus on recent changes in firm fundamentals (...) and an assessment (...) accomplished through a careful study of historical financial statements (...)

His procedure is, that he creates a set of 9 simple financial ratios,the so called F_Score. Basically, without going into too much detail here, those 9 financial ratios are derived from a set of 3 financial performance signals.

• Financial performance Signal: Profitability ==> firm's ability to generate funds internally; (...) relationship between earnings and cash flow level is also considered through evaluating earnings driven by positive accrual adjustment (i.e. profits greater than cash flow from operations) ==> bad signal

•  Financial Performance Signal: Leverage, liquidity, and source of funds (...) change in long- term debt (...) view increase (decrease) (..) as a negative (positive); change in liquidity measures the the historical change in the firm's current ratio between the current and prior year; change in equity offering (...) raise external capital could be signalling their inability to generate sufficient internal funds 

• Financial Performance Signal: Operating Efficiency: he defines change in margin as the firm's current gross margin ratio less the prior years gross margin ratio; change in asset turnover = firm's current years asset turnover ratio less the prior year's asset turnover ratio (..) an improvement signifies better productivity from the asset base

He than classifies each firm's signal realization as either "good" or "bad" (...) and indicator variable for the signal is equal one (zero) if the signal's realization is good (bad) (=individual binary signals). The aggregate signal  is designed to measure the overall quality, or strength, of the firm's financial position (...) the so called "F_Score" which is the sum of the individual binary signals (...) and can range from a low of 0 (=weakest companies) to a high of 9 (=strongest companies).

Selecting Cheap Stocks: Piotroski' Findings

•  the evidence (..) shows that portfolio of healthiest value firms yield both higher returns and stronger subsequent performance. The inverse relationship between ex ante risk measures and subsequent returns appears to contradict a risk- based explanation (...)

•   (...) above market returns earned by a generic high BM portfolio are concentrated in smaller companies (...) strongest benefit from financial statement analysis is garnered in the small-firm portfolio (...) differentiation is  weak among the largest firms (...)

• (...) when return predictability is concentrated in smaller firms, an immediate concern is whether or not these returns are realizable (...) with low share price or low level of liquidity, observed returns may not reflect an investor's ultimate experience (...) Consistent with these firm's small market capitalization and poor historical performance, a majority of all high BM firms have smaller share price and are more thinly traded (...)

• (...) majority of the high BM portfolio's "winners" are in the low share turnover portfolio (..) one of the largest returns to the fundamental analysis strategy is in the low volume portfolio (...)

• (...) high BM firms are not heavily followed by the investment community. As such, financial statement analysis may be a profitable method of investigating and differentiating firms (...)
• (...) returns earned by a generic high BM portfolio are concentrated in firms without analyst coverage (..) significantly outperform the value-weighted market index (...)

• The concentration of the greatest benefits among smaller, thinly traded, and under-followed stocks suggests that information-processing limitations could be a significant factor leading to the predictability of future stock returns.

 

Selecting Cheap Stocks: Piotroski's Final Conclusion

(...) results are striking, because the observed patterns (...) inconsistent with common notions of risk. Fama and French(1992) suggest that the BM effect is related to financial distres; however, among high BM firms, the healthies firms appear to generate the strongest returns. The evidence instead supports the view, that financial markets slowly incorporate public historcal information into prices and that the "sluggishness" appears to be concentrated in low- volume, small and thinly follwed firms.

These results also corroborate the intuition behind the "life cyle hypothesis" advanced in Lee and Swaminathan (200a;200b). They conjecture that early-stage momentum loser that continue to post poor performance can become subject to extreme pessimism and experience low volume and investor neglect (i.e a late stage momentum loser). Eventually , the average late-stage momentum loser does "recover" and becomes an earlystage momentum winner. The strongest value firms in this paper have the same financial and market characteristics as Lee and Swaminathan's late-stage momentum losers.

Since it is difficult to identify an individual firm's location in the life cycle, this study suggest that contextual fundamental analysis could be a useful technique to seperate late stage momentum losers (so-called recovering dogs) from early-stage momentum losers.

Personal remarks concerning Piotroskis findings and Japanese high BM stocks

I really like Piotroski's concept, as it qualifies for the KISS principle (Keep it stupid and simple). Most people like to follow complex  strategies, because it makes them look so smart. I don't! Because when I learned something it is, that I am not in the business of looking smart, but in the business of money allocation. Simple strategies help you to be coherent and consistent in allocating your capital. Complex strategies do not.

As mentioned several times before on this blog, japanese net-nets and high BM stocks are often of very high qualitiy and a great amount will qualify easily for high F_scores. Actually a bunch of them are so qualitative that one could add a few signals to Piotrosky's concept of F_score when applying it to japanese high BM firms. For example dividend paying and/or increase in retained earnings. Or a extra score for stock repurchases, etc.

Piotroski`s findings that especially thinly traded stocks with high F_scores perform best is very encouraging It confirms what Benjamin Graham always said; that low volume in a stock should not discourage an investor taking a position in an issue that shows compelling quantitative readings. It is a huge advantage for the small investors over the big investment boutiques. We don't have too many and it would be a negligent act not to monetise on that one!

Strange I find, that Piotroski couldn't find any evidence that a high BM portfolio of low priced stocks outperform a high BM portfolio of high priced stocks.

"(...)Low priced common stocks (..).possess an inherent arithmetical advantage.(..) can advance so much more than they can decline. (...) give the owner the advantage of an interest in, or "call upon", a relatively large enterprise at relatively small expense.  (..).most people who buy low-priced stocks lose money on their purchases.(...) bulk of the low priced purchases made by the public are of the wrong kind, i.e. they do not provide the real advantages of this security type...(they are) low priced in appearance only.(...) A genuinely low-priced common stock will show an aggregate value.(...) small in relation to the company's assets, sales, and past or prospective profits."

"(...) companies facing receivership are likely to be more active than those which are very low in price merely because of poor current earnings. This phenomenon is caused by the desire of insiders to dispose their holdings before the receivership wipes them out, thus accounting for a large supply of these shares at a low level.(...) But where a low-priced stock fullfills our conditions of speculative attractiveness, there is apt to be no pressure to sell and no effort to create buying. Hence the issue is inactive and attracts little public attention (...)."

(Source: Security Analysis 1st Edition page 473 ff.)