Posted on | August 31, 2012 | No Comments
Will you help somone today?
What will it take? Some of you may answer. I already do a boatload. Great. Others will answer the question, No, I don’t want to help anyone but myself. But what if you could do it with…
I have written about various investments that have not so great financial returns but have other social rewards. These include providing capital for mircobusinesses in the United States and abroad. I mainly use two vehicles for this Microplace.com and Kiva.org.
Ask yourself what incentive you need to more than $25, for free. Think of it as an incentive to be a Do-gooder.
Kiva has extended me the opportunity to help you to try out their service by subsidizing your first investment to the tune of $25. That is right. You will get a free investment in Kiva.org by following this link. No strings attached. My hope and their hope is that in this zero percent interest world that it makes sense to invest directly in people and work creation. And that this notion has merit on its own. This is a limited time offer. Once they run out of the subsidies, the offer ends. I do not benefit from this financially.
Posted on | March 29, 2012 | No Comments
Sometimes I will come across an article that will inspire a post. This is one of those types of articles. One of the advantages of AAII is that they send you updates weekly. Recently they posted something that I knew about, but that should give every individual investor pause.
Most Actively Traded Funds Underperform Index Funds
They were reporting on the 10th annual SPIVA (S&P Indices Versus Active Funds) Scorecard. Here is the quote that caught my eye, ” The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”
Yup. This isn’t news really. It has been a persistent problem in investing. It is hardly a secret.
But wait, it is probably worse than you think it is. Here is the percentage of funds that underperformed the significant index in each category.
- Domestic Large-Cap Stock Funds: 61.93%
- Domestic Small-Cap Funds: 72.56%
- Domestic Real Estate Funds: 70.24%
- International Stock Funds: 77.98%
- Emerging Market Funds: 82.89%
- Government Long-Term Bond Funds: 93.62%
- Investment Grade Long-Term Bond Funds: 96.77%
- High Yield Funds: 96.06%
- General Municipal Debt Funds: 90.24%
Why would you invest in an actively managed fund over an index if 9 out of 10 underperformed an index. But that is just what would have happened if you invested in a bond fund. This is probably why Warren Buffett has said, “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”
Do Any Actively Managed Funds Have and Advantage?
Was there any good news? Yes. International Small Caps may be a place to consider utilitzing an active fund. “Only 26.09% of actively managed international small-cap funds lagged their benchmark over past five years, and the one-year number is not considerably higher at 38.18%.”
If actively managed funds, which often have higher fees and trading costs than index funds are not outperforming an index, they are destroying value. As an investor you must be good at allocating capital. If the reason you would invest with an active manager is that you don’t want to research stocks or bonds, then you may want to consider an index fund.
Of course, I believe that with a little effort and small individual investor has advantages over many large investors.
Posted on | March 15, 2012 | 2 Comments
One of the things essential to discovering your own investing strategy is discovering what people have tried before you. In the distant past, pre-web, people read books, because I am old fashioned, I still read them. And surprise, they are still valuable today. I have added a new section to Chroma Investing; A Value Investing Books section. This will only feature books that I have personally read. Some are better than others, some of the author’s have biases that obvious, but that doesn’t mean everything they say is wrong. It is important to cultivate ideas in investing outside your own. And heresy of heresies, even outside value investing. The section can reached by selecting the tab at the top called “books.” Please take a look.
Posted on | March 13, 2012 | 7 Comments
or More random items about what this blog is about than you really wanted to know
This is a reworked article that I posted back when Chroma first started, but no one read it, so it is new information to anyone hanging out now.
What is this Value Investing Blog about anyway?
Since you are at my blog, I will summarize to you what I think is important. This is not a complete list. These ideas are not listed in any particular order. You didn’t go to Gray investing. This is Chroma Investing. Hopefully I can bring a little color to what everyone else seems to think is black and white. There are hundreds of blogs about investing and many have not just different but contradictory ideas. Which is correct?
Figuring out what is right and what is a load of crap takes time. If you don’t understand the basics of investing, you will have to learn them. Hopefully that is part of why you are here. And that you like sarcasm. That is a bonus. If I am tired I often leave it out.
Investing Advice from a non Professional
1) Take it slow. You didn’t learn to drive in a day. You won’t learn how to invest in a week. There will still be good deals whenever you are ready. Don’t invest with real dough until you have worked through the fundamental investing ideas enough so that you know how you want to invest. That means if someone says they have a great tip, that you better get in now, before the market closes in fifteen minutes. Pass. Run away. They may be right. But you won’t be able to figure it out that fast. Unless have already done research on that particular company. And you believe them. And they are right. That’s a lot of “ifs.”
2) as Graham said, you need to make sure you are protecting your capital before you are earning on it. O.k. that is a paraphrase. And not a very good one, but the idea is right. There are a million ways to lose your money. Don’t jump off the bridge, unless the bungy cord is properly connected. Make sure you are not taking unnecessary risks or being rewarded too low for the risks you are taking.
3) Get out of debt. This is an easy one. Unless you are the next Warren Buffett you will not be making more money from investing that you are paying on credit card debt. Unless you have been able to secure some incredible deal on a loan, you will be burning cash until you get out of debt. That said, even the master Buffett has used leverage ( a fancy word for borrowing) on occasion. If you know what you are doing, leverage is not a bad thing. Used sparingly and fully understanding the risks. Even many of the financial professionals seem to misunderstand the risks involved with leverage. Just ask Nassim Nicholas Taleb the master of explaining risk and probability and how stupid we really are in understanding it. Taleb is at least a week of posts given the importance of his work in understanding down side risk. (Taleb has two great books that are must reads for humans and doubly so for investors. They are [easyazon-link asin="1400063515" locale="us"]The Black Swan[/easyazon-link] [easyazon-image align="none" asin="081297381X" locale="us" height="75" src="http://ecx.images-amazon.com/images/I/41CeS0f8VPL._SL75_.jpg" width="49"] and [easyazon-link asin="1400067936" locale="us"]Fooled by Randomness[/easyazon-link])[easyazon-image align="none" asin="1400067936" locale="us" height="75" src="http://ecx.images-amazon.com/images/I/41DKbqY1yVL._SL75_.jpg" width="49"].
Investing Well Means, Investing Differently
4) Have fun. Seriously. If you are not having fun investing for yourself, you will probably cut corners on your research, or fail to update your spreadsheet or valuation tools. Or fail to grasp the fundamental principle that investing is a zero sum game. If you wine somebody else lost. If you aren’t having fun, drink good wine instead. Some people are beer drinkers, not investors, enjoy the brew instead.
5) Be comfortable with the fact that you will never, ever have perfect information about anything you invest in. I am not kidding. This is one of those facts that most people missed in the course of college, or grad school, or kindergarten, whenever they got the best info in their life. You will need to embrace the unknown. If you understand the Macro side of economics, you will miss the Micro side. Many professionals will have a problem with this point. Ignore them, this isn’t their blog.
6) Don’t be afraid to keep your money in cash. If you don’t know what to do, or no good deal presents itself to you- Do nothing. Remember Benjamin Graham- preservation of capital first. Be Patient and be confident in your choices. Then change with new information.
7) There are always deals to be had. Sometimes they are good, sometimes they are great. Sometimes they suck donkey. Go for the great ones. If you can’t find anything that looks great to you see point Six again.
8)Don’t be afraid of annual reports. Annual Reports are like [easyazon-link asin="0071448209" locale="us"]Security Analysis[/easyazon-link] [easyazon-image align="none" asin="0071448209" locale="us" height="75" src="http://ecx.images-amazon.com/images/I/51jk-rpndQL._SL75_.jpg" width="49"], everyone says they read them, but few people do. Apart from the numbers most of the good stuff is the gems that tell you to run the other way. Good info and sometimes they put right there for everyone see.
What Makes You Different as an Investor?
9)Develop an investing strategy. Listen to everyone you can read. I will expose you to a bunch of great sites and books and investors. Take it all in. Then figure out what makes sense to you. If it doesn’t make sense you dump it. It doesn’t matter if your neighbor Tom has made a killing in Apple stock. If you don’t understand how he did, or if you understand but, it doesn’ add up some how, then find another strategy. Your goal is not to be like other investors but be better. Your goal is to make money.
10) Know what your edge is. Warren Buffett has said stay in your circle of competence. To me this means that we all have special knowledge and talents. Get some self knowledge and decide how that gives you an edge. Low volume penny stocks for example can be an edge for small time investors over mutual funds. IF you can’t stand all the detail pick an investing style that doesn’t involve combing through boring reports.
11) if your investment has a looming catalytic event or person, or group. Pat yourself on the back. I like catalysts like liquidation. It helps develop a time frame for your stock investment. But don’t count on it.
12) Make sure you have an Roth IRA. Remember if you do well in investing you want to keep your profits. I love the USA, I just don’t want them taking all my hard earned investment profits.
Buffett is a Genius but you Can’t be Like Him
13) Buy and Hold forever isn’t an investment strategy. Buy and hold is a great strategy for Berkshire Hathaway, the corp that Buffett runs. They are huge and you can’t move ships that big, very quickly. But the nimble small time investor needs to be clear when an investment is good to buy and when it is good to sell. Buffett didn’t follow his own advice when he was younger and had hedge fund like partnerships. See tip ten again. What is good for Buffett now is not necessarily a good deal for a beginning investor.
14) Don’t deworseify your investments. Peter Lynch coined the term. Stick to your good ideas. No small time investor should own 40 stocks. You don’t have time to track that many companies actively. Time is of the essence.
15) Do not dollar cost average. This is an idea so patently stupid it must have come from the same geniuses who gave us the Effecient Market Theory. Why would anyone invest in anything when it is clearly overvalued? Bet big when the deal is good, stay out when the deal is bad.
16) Research companies in advance. Have a watchlist of companies you might be interested in buying at the right price. Have a buy in price. If the price drops unexpectedly, you will be ready like a vulture to swoop in for the kill.
Be a Contrarian Investor
17) Falsify First. Don’t sprint into trying to prove your latest, greatest theory is correct. Try to disprove it. Take a shotgun to it and try to fill it with holes. Karl Popper would be happy.
18) Don’t follow the herd. Really. There are a lot of stupid people investing. They are not stupid because they lack intelligence, but because they lack the courage to be different and discover for themselves what is a good investment strategy and a dumb one.
19) Consider some form of mechanical investing. I know this takes some of the ego out of the investing process. But really, would you rather have a fat investment account or take credit for the intelligence of all your investing ideas. (Yes they are often mutally exclusive) Wait, most of you are answering the wrong way. The right answer is get out of the way of your investing decisions and make money.
O.k. so maybe that wasn’t 20 things about value investing, but it is close enough. I think I said everything I needed to say with this blog. I guess I can retire.
Disclaimers: If you go to Amazon and buy a book I am hocking, I get a tiny, very tiny commission. You will have my gratitude and you can feel good knowing that you have supported a worthy cause: this site. I am not a professional investment advisor, you shouldn’t follow anything I say or even what professional investment advisor says without checking it out yourself. This is the internet. Its mostly all crap.
Posted on | February 27, 2012 | No Comments
After another unplanned work related hiatus and subsequent vacation Chroma Investing will begin publishing articles again. Sorry for the lapse, but since I don’t make money off this site paid work comes first.
Posted on | September 28, 2011 | No Comments
The Value Investing Congress in New York, has just added David Einhorn as a speaker. Einhorn is an author and the hedge fund manager of Greenlight Capital. He has made headlines in a few of his short positions, although, he claims to be a net long investor. Shorting usually does generate more headlines because it is a contrarian position to take. He originally caused quite a stir when he shorted Allied Capital which was chronicled in his book Fooling Some of the People All of the Time. It is a book I have read and recommend for glimpsing inside the hedge fund industry and what companies like Greenlight do before they short a company. Undoubtedly, the book is self serving at times, but it is a fascinating read.
Einhorn’s other notable shorts were Lehman Brothers and more recently St. Joes, where he is pitted against Bruce Berkowitz who has a substantial long position. Einhorn is often a controversial speaker, and it would not surprise me if he announces a new short position, or interesting long position at the congress. Today is the last day you can sign up through the Chroma Investing and get the Value Investing Congress discount saving you $1000. The conference is a few weeks a way from Oct 17-18th.
If you would like more information on who is attending you can go to Value Investing Congress or to my page devoted to Value Investing Conferences.
Posted on | September 20, 2011 | No Comments
It recently occurred to me that I did not have enough how-to type articles at Chroma Investing. So this will be the first in an on going series of how to value investing articles.
How to Pick a Value Investing Conference
The first thing to do is start with value. This is not a surprise statement on this website. As always, value is in the eye of the investor. What is a great value?
Start With Your Assets
What? Yup, Start with your assets. If you are small time value investor, or a young person just beginning to invest, you may have very little money to invest. You may be struggling to pay off credit card debt or scrimping to save up your first bit of capital to invest. Or you may be flush with a retirement fund or come into a big inheritence that you have decided you can invest better for yourself.
If your total capital is only $2000 it doesn’t make any sense to spend $2000 attending a value investing conference no matter how great it is. On the other hand a conference such as the American Association of Individual Investors conference which is only a couple of hundred dollars may be a great way to kick start your early investing efforts. In particular investing conferences are terrific avenues for asking questions, clarifying investing ideas and meeting like minded individual investors.
On the other hand, if you have a portfolio of $500,000, spending a few thousand dollars to attend a great event like the upcoming Value Investing Congress, won’t hit your underlying capital and may actually provide insights that can energize your investing process.
What Value Investing information are you looking for?
Value Investing conferences are essentially tools to help educate yourself as an investor. Look through the websites of the investing conferences you are interested in to see who is speaking and what topics they are covering. Some of the topics at upcoming value investing conferences include: Value Investing today, Finding Outstanding Investments, Global Value Equity Investing, Emerging Markets: Overheated or Alluring?, Sustainable Investing: Not Just for Hippies Anymore, and this tongue twister: How to Decipher Financial Statements, Avoid Value Traps, and Pick Investment Winners. There is a lot of variety at investing conferences so you need to figure out what you are interesting in learning, what can complement and expand your investing knowledge. Only you can assess what you know and what you don’t know.
Value Investing Conferences can also focus on practical investment knowledge, such as actionable equities analysis or investing case histories. All knowledge is not the same. After some investing conferences you walk away with value investing strategies and others with specific stock picks from great investors. There is no right answer, it will depend on what you are looking for.
Who is speaking at the Value Investing Conference?
Another important factor influencing your decision to attend an investing conference is who is speaking. At next year’s Value Investor Conference in Omaha several of the speakers are best selling authors as well as fund managers. I have read Robert Hagstrom’s The Warren Buffett Way, he is now a portfolio manager at Legg Mason. Pat Dorsey used to be director of Equities Research at Morningstar when he wrote the book, the Little Book that Builds Wealth, part of that popular investing book series.
If you like to hear the superstars of Value Investing speak, it is hard to beat the Value Investing Congress. Next month hedge fund manager Bill Ackman, who I have profiled recently, Joel Greenblatt, author of one of my favorite investing books, How to be a Stock Market Genius (yeah I know it is a dumb title, but it is a really good book) The Little Book that Beats the Market and his most recent book the Big Secret for the Small Investor. And if you don’t know him from his books you may know he is founding partner of Gotham Capital and phenomenal investor.
The most important thing to remember about investing conferences is that they are not THE answer to value investing, but they are a fantastic tool to learning or refining you knowledge of Value Investing.
If you want more information on any of the conference go the Value Investing Conference page.
Disclaimer: I am a media partner with Value Investing Congress.
Posted on | September 10, 2011 | 3 Comments
This is a value investing Website filled with all things value investing: Value Investing Strategy, Value Investing Conference, Value Investing Software.
But what is Value Investing?
This is obviously a beginning investor question. But weekends are for beginning value investors, since that is probably when they have time to investigate their investing strategies. In layman’s terms, Value Investing is about buying something for less than it is worth, whether its socks or stocks. Investors who use this form of analysis are called Value Investors. Famed value investors are Warren Buffet who began his career as a value investor and Sir John Templeton, Seth Klarman and Joel Greenblatt. But the Godfather of Value is Benjamin Graham.
Origins of Value Investing
Because of their 1934 book, [easyazon-link asin="0071448209" locale="us"]Security Analysis[/easyazon-link] [easyazon-image align="none" asin="0071448209" locale="us" height="75" src="http://ecx.images-amazon.com/images/I/51jk-rpndQL._SL75_.jpg" width="49"], Benjamin Graham and David Dodd are regarded as the pioneers of value investing. This book provided the investment community with a concept of value investing, although it did not gain that moniker until later. The value duo chastised the investment community for being too short sighted. Oh, and obsessing about earnings. Some things in investing don’t change much. The real importance of Security Analysis is that it provided a set of criteria, what would later become the value investing criteria for individual stock selection.
Ultimately Graham says, “But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science.” No kidding. That is why he developed the concept of a margin of safety. Investing, even value investing, is not precise so you need to have a buffer.
Graham’s 1949 book, [easyazon-link asin="0060555661" locale="us"]The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)[/easyazon-link] [easyazon-image align="none" asin="0060555661" locale="us" height="75" src="http://ecx.images-amazon.com/images/I/41rcIrKhYiL._SL75_.jpg" width="50"], was widely acclaimed with Warren Buffett cementing its reputation by commenting that it was,” by far the best book on investing ever written.”
How to value a Value Investment
So, how does one know if a stock is undervalued or not? As with most things in life, keep it simple. Value Investing is at heart a contrarian investing philosophy. We look for the out of favor, the unpopular and the beaten down to discover what is a bargain. Numerous directions can result in a value investing strategy. Here is one example.
The search begins by analyzing a company’s financial statements. From the balance sheet, calculate the book value, simply, total assets-total liabilities. Dividing book value by the number of shares outstanding on the balance sheet date, you arrive with a book value per share figure. Comparing the current stock price and book value per share gives an investor a good start in determining if the stock is undervalued or not. . I have written previously about a low price to book value investing strategy. Compare this ratio to the companies industry or the market as a whole.
Complications can arise. Intangible assets such as brand names, patents and trademarks come into play and can affect calculations, which is why price to Tangible book is often used instead of the traditional price to book value.
Should I become a Value Investor?
It’s natural for a beginner to ask, “How do value investor’s performance fare against the market?” The weird part is that there is so much research showing that value investing is superior to “growth” or technical investing that you would think everyone would be a value investor. Fortunately, for you and I that is not true.
A good illustration is Warren Buffett’s article in 1984 titled, The SuperInvestors of Graham-and-Doddsville. Buffett challenged the ‘efficient market” theory and compared the performance of Graham and Dodd’s value investors against the market. He argued that if a large proportion of the winners belong to a particular group who practice value investing, their success is due to a winning strategy, not by chance as efficient market theorists assert.
In summary, value investing could be called by common sense investing, in a world where common sense is rare. . Look around chroma investing, it is free. There are not many better value investments than free.
Posted on | September 1, 2011 | 4 Comments
This is going to be a denser than usual article. If you want to skip the theory and go to the section that deals with the mechanics of the strategy, go ahead.
But don’t skip this article.
I have wanted to write this article for a long time. It is essential because I use this value investing strategy as part of my 80-20 Portfolio stock selection. This is one of those value investing strategies that gets a lot of attention, but then is often depicted incorrectly. So if you skip to the why the F-score is so great section, please read to the end from there.
What is Piotroski’s F-score?
In his landmark study, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Joseph D. Piotroski sought to investigate whether it was possible to take the long established advantage of low Price to Book (or in academic terms High Book to Market) companies and gain an advantage in investment returns. This paper is thick and difficult to understand if you are not well versed in investing terms.
I will summarize the paper briefly, then get to the results and why it MAY be appropriate for investing. I have supplied the paper for download, although to be honest, it is a pretty tough slog for those of us not trained in advanced math.
First the background.
In the Introduction he introduces the idea that “investors can create a stronger value portfolio by using simple screens based on historical financial performance…the differentiation of eventual “winners” from “losers.”
Nice to have a little support on the use of Value Investing Screeners.
In section 2.1, Piotroski discusses the previous research of low Price to Book stocks, some of which has been discussed previously on this website.
In section 2.2 One interesting and important note is that ,”financial analysts are less willing to follow poor performing, low-volume, and small firms (Hayes 1998, MCNichols and O’Brien 1997), while managers of distressed firms could face credibility issues when trying to voluntary (sic) communicate forward-looking information to the capital markets (Koch 1999; Miller and Piotroski 2002).” Why is that important? The implication is that analysts are unlikely to be following a company and thus little information about a companies prospects are likely to be disseminated to the market. This can create inefficiency in the marketplace. It also points to a potential catalyst in this strategy and that is that a stock gaining analyst coverage could expect to have a large price swing, (hopefully positive, if we have invested in it).
In Section 2.3 Piotroski highlights that most low Price to Book companies are “financially distressed (e.g. Fama and French 1995; Chen and Zhang 1998).“He states that his F_score will be based on nine binary signal from the financial data. That is the sum of nine yes or no questions. The context is important. The results of some of the individual criteria can be “ambiguous.” “For example, an increase in leverage can, in theory, be either a positive (e.g. Harris and Raviv 1990) or negative (Myers and Majulf 1984; Miller and Rock 1985) signal. ” Obviously, for financially distressed companies the likely result is negative.
The problem with low price to book companies is that many of them fail because the companies genuinely do have problems. To be a good value investor you need to be able to weed out the losers from the winners. The importance of his study is that Piotroski felt that you can find the best of the worst by answering some fairly simple yes-no financial questions and thus increase your returns. The results you can see coming up.
How to measure the F-score
The next few sections lay out what the binary measurements of the F-score are. If it passes the measurement it gets a 1, if it fails it gets zero. Add up all nine elements and you have the F- score. If you do not plan on calculating this yourself or ensuring that software you use is calculating it correctly, you can skip to the next section. But I recommend slugging it out, so you can understand some of the calculations that help determine whether or not a company is worth investing in.
In section 2.3.1 of his study Piotroski lays out his measurements for Profitability. Their are four: Net Income, Cash Flow from Operations (CFO), Change in Net Income, and the difference between CFO and Net Income. Profitability is important because in his research 41.6% of low price to book firms have experienced a loss in the previous two years. Here is how it breaks down.
1. Net income, (is defined as before extraordinary items) must be positive. Positive means 1 point, negative zero points.
2. Cash Flow from Operations must be positive. Both one and two in Profitability are a result of the point above that over 40% of low price to book companies have suffered a loss recently.
3. Net income from this year must be greater than the previous year. IF it is one if not zero.
4. Cash Flow from Operations must be greater than Net Income. Piotroski makes this clear, “Sloan (1996) shows that earnings driven by positive accrual adjustments (i.e., profits are greater than cash flow from operations) is a bad signal about future profitability and returns.”
Leverage and Liquidity
In section 2.3.2 Piotroski discusses Leverage and liquidity. Leverage describes how indebted a company is. Do they owe more than they can pay. Liquidity is really a companies ability to pay its bills in the short term. It may be that you have plenty of assets that cannot be easily converted to pay the bills in the near term. Both of these can cause a company to fail.
5. Change in Ratio of Long term Debt to Total Average Assets – This is the leverage question so, if the ratio should fall from year to year give your company one point, if it rises zero.
6. Current Ratio- Is an often used measure of liquidity. The Current ratio should increase from one year to the next. Interestingly, the study does not set a minimum that current ratio should be at.
7. Equity offering- the firm should not issue any new stock during the previous year. If a company is issuing stock when the price of the equity is cheap, they are incurring a high cost of capital and it is more evidence of financial stress.
2.33. Operating Efficiency
8. Gross margin ratio improves- That is gross margin to total sales, less the previous gross margin ratio. This difference should be positive. The reason for this is that an increasing gross margin is likely coming from an important improvement in the underlying business such as rise in price of products, lower cost of inventory, or other such factors.
9. Asset turnover ratio improves- Piotroski defines asset turnover ratio as the total sales for a year to total assets from the beginning of the year. Compare to the previous year’s asset turnover ratio. If there is an increase add a point, if not zero. This makes sense when you see that an improvement implies one of two things: more sales are being generated by the assets or more sales are being generated with the same assets. Both positive signs.
To get the F-score you add up all these 9 factors to get a number from zero to nine. That number is the basis for everything to come.
How the F-score study was set up
Many of these academic papers are hard to understand and so is their methodology. For example, Piotroski picked a period of time 1976 through 1996. And then he evaluates which firms have sufficient data to study. These are important points that I will return to later.
He divided the companies into quintiles or 20% groupings based on price to book value (book to market is the inverse that academics use). He would randomly create a pseudo portfolio of companies that fit into different categories and then look at results of his F-score on the companies. As Piotroski states, “most of the observations are cluster around F-scores between 3 and 7, indicating that a vast majority of the firms have conflicting performance signals.”
Why Piotroski value investing is so great
So what did Piotroski find? He found that a low price to book investing strategy can be improved by at least 7.5% per year using by picking high F-score companies. Hi F-score companies were defined as having an 8 or 9. Low F-score companies have a value of 0 or 1. A value investing strategy that bought high f-score and shorted low F-score companies theoretically generated a 23% annual return between 1976 and 1996. My reading of the paper also yields that 1 year mean return for F-score companies from 6 through 9 was 11% and higher. Two year market adjusted returns of high F-score companies were 16% above the market. So is there anyway using his data to goose these returns. Sure.
1 year market adjusted returns were significantly better when buying the smallest third by market cap: 17.9%. Significantly the drop off in returns again occurred below an F-score of 6. The mean return for 6 and 7 were actually higher (18.2%) than for 8 (17%). Low trading volume also boosted returns for high F-score companies 16.7%. And high f score companies that have no analyst following had a median 18% return in a market adjusted returns.
The American Association of Individual Investors has a screen that is a version of this strategy. The purported results shown have had astronomical returns. It has shown a ten year return of 26.3% annually vs. .6% for the S&P 500.
Misuse of Piotroski’s F-score
One of the most shocking things I learned is that even though the F-score is not new, even to many value investors, its correct implementation is. Perhaps, people are looking for a quick fix and so they often start by ignoring the screen that Piotroski ran before evaluating companies with his 9 questions. To achieve the best results previously mentioned an investor must screen for the bottom 20% of price to book value stocks. Remember Piotroski was trying to sift the best from the bad.
How the F-score is misused. First, his research really only showed that it has significant predictive value among the bottom 2/3 of market capitalization. It doesn’t really work on large cap stocks. So if you try to apply the F-score to a large cap stock with a high book value, it isn’t going to help. Be sure you understand how to properly use the F-score to assist in value investing.
The normal idea in investing that increased risk is at the heart of higher returns seems to be incorrect in the case of the high F-score companies. Since the companies are low price to book companies, they should be higher risk, but their financial soundness actually shows them to be less risky. Interestingly, in his conclusion, Piotroski seems to say that he doesn’t have all the answers, it doesn’t “find the optimal set of financial ratios for evaluating the performance prospects of individual value firms…”
A few instances where I have seen incorrect use of the F-score. The Graham Investor has an F-score screener that does not screen first by low price to book. This gives the impression that there are numerous F-score 9 companies available, but in fact that there were only a handful of high F-score stocks trading this week.
Should you use the F-score and become a Piotroski value investor?
One of the things that makes this difficult to answer is the previous results I have written about. They are very alluring. But the problem with academic studies is they are often difficult to realize in the real investing world.
Are you really willing to invest at one time a year to make a system work? What if the companies that Piotrowski excluded because of insufficient data would have created a different result?
Does the small size of the firms and liquidity of trading make it difficult if not impossible to get a “real” f-score portfolio?
These are good questions, even if I had to ask them.
They are reason that I would not, personally, use the F-score alone. But I don’t use as a solo investing criteria, but use it as part of my 80-20 value investing strategy. Another problem is that like Net Net stocks, when the market gets expensive there are often a paltry few to choose from. A low F-score may also be an important factor to use, like the Altman’s Z score, to rule out a potential investment, which can help reduce downside risk.
If you are a value investor, you many already be looking at small to mid cap companies with very low price to book ratios and no analyst coverage. If so, think of the f-score as a valuable addition to your value investing toolkit, like attending a value investing conference, or using the right value investing software.
Posted on | August 29, 2011 | 2 Comments
Beta is a funny looking Greek character that gets thrown around a lot in finance circles. It can be used to estimate correlation of an asset to the over-all market.
If you compare an asset, say stock in a company, to a market, say the S&P 500, you can establish a relationship between them. For example a beta of zero means that the stock will move independently of the market. A beta of one means they are perfectly correlated.
Beta is also mistakenly used as a description of risk. As Ben Graham said, “Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”
Amen, brother. Sometimes it is better to let Ben Graham speak and get out the way.
Another thing to remember, in a crisis all assets have a beta of one.