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.

Profitability

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.

Operating Efficiency

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.

Related Posts:

• Value Investing Ideas – Companies Passing my Custom Screens
• Warren Buffett’s advice in a Crisis
• Best Value Investing Screeners
• Real Returns are the only Returns that Matter
• Pareto’s Principle – A Name for an Old Rule

I promised that I was going to be adding more value investing features to this website. One of them is going to be a weekly list of companies that pass a few of my custom value investing stock screeners. Each week I will highlight a different custom Value Investing screen I use when deciding to do further research on a company. This week I will highlight the 80-20 Screener;

80-20 Value Investing Screen

80-20 value investing Screen 8-19-11

I have attached a screen shot of part of my custom 80-20 Value Investing stock screener using Stock Investor Pro screen which is comprised of the following value investing elements:

Low Price to Book Value

1. Price to Book ratio in the bottom 20% of stocks screened. I have documented the low price to book strategy in the past.

High Piotroski F-score

2. a Piotroski F score of 7 or better. ( I will be high lighting this study in an upcoming article, that will be a must read article!) This helps weed out some of the worst companies.

Low growth in assets

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth). Studies have shown that companies with the lowest 20% of growth in assets outperformed the market as a whole.

Pass the Z-score

4. A passing score on the appropriate Altman Z score. That means above 3.o for Manufacturing companies and 2.6 for other companies.- This is for downside risk protection since the Z score helps warn of potential bankruptcies.

Good Net Current Asset Value

5. Net Current Asset value equal to or greater than 1.25 times market cap. I am looking for companies with assets close to NCAV.

Current Price Earnings Historically Low

6. Ratio of current P/E to 7-10 year P/E is less than 1.  I borrowed the next two criteria from James Montier.

Low Price to Sales

7. Price to Sales ratio  less than 1.

The purpose of this to aggregate multiple value investing criteria

Value Investing Ideas

I have not yet investigated any of the stocks on this list, but I intend to begin to evaluate at least one of the stocks a month beginning in the next couple of weeks, so please return.

Highlights of this weeks value investing screener.

Benchmark Electronics BHE is a new entry to this list and worth a look.

Several of these stocks trade with almost no volume or have very very limited financial information. Some of those include Chai-na-Ta Corp. CCCFF, Elegant Illusions EILL, Sonics& Materials SIMA.

Satyam Computers SAYCY is an Indian company that had a very large accounting scandal, so unless the issue of assets has been resolved satisfactorily, may be a false positive to passing the screen.

Good luck on your research, if you choose to take these companies to the next level of research. If you do, please report the results here.

Disclaimer: I do not currently have any holdings of any of the companies listed on the screener. I may without notice buy one of these equities, if I find it fits my investing needs. Nothing in this post or this website should be construed as investing advice. I am merely expressing my opinion and sharing what interests me in the value investing arena. Please do your own research.

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• 3 Must haves for your Value Investing Notebook
• Best Value Investing Screeners
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• 80-20 Investing – the Portfolio
• Great Value Investing Strategies – Piotroski’s F-score Investing

Buffett Quotes

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful. ”

“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. ”

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. ”

Conclusions

I know I have been quoting Warren Buffett, but another analogy, that comes from Ben Graham may be more in order and that is of Mr. Market. Mr. Market is panicked right now and he is starting to hand out bargains. Because he is panicked doesn’t mean we need to be. My equity portfolios are down like everyone else’s, but I have had nearly a third in cash in my IRA in cash and 80% in cash in the two investing accounts for Chroma Investing: the Small Investor Portfolio and 80-20 Investing Portfolio.

Take another look at your watchlist and you may see investing opportunities that did not exist a few weeks ago. That is what I am doing.

Related Posts:

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The best place to find value investing screeners is to start at AAII.com. This is the website of the American Association of Individual Investors. To get access to the company names of the stocks that pass their dozens of screens you will need to join. The yearly membership is a mere $25, a great value! But you can go to the aaii screeners and begin to look through the various choices they have for free. This shows recent performance and as far back as 10 years. I have included a snapshot of the overview page.

AAII.com stock screener overview

This page you can see without joining to check out the various types of screeners they have which include Buffett type stocks, Dividend stocks, Dogs of the Dow, Philip Fisher type stocks, Piotroski F score stocks. There are value investing screeners, momentum screeners, growth screeners and combos.

AAII also includes the screening criteria, so you can see exactly what they are including to get the passing companies. Stock screeners are good starting places for a value investor, but it is not as simple as buying a stock that is on a screener you like. You will need to do your own due diligence. The several reasons for this include, outdated financial reports, a massive change in products or services offered, lawsuits, allegations of fraud (a common problem with Chinese companies that make some of the screens).

A great value investing screen like the Piotroski F score may not be performing well (down over 10% year to date) and that may influence whether you want to invest in that system now. Personally, under-performance is always a something that I like to look at and see if their is an investment opportunity.

More Value Investing Stock Screeners

Follow this link to get more information on Value Investing screeners.

Disclaimer: I do not benefit financially from recommending aaii.com. In fact I pay to be a member and I pay them for other services.

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I have long maintained that the only return that matters is total return. What this means is, simply, if I have an investment account of $10,000, at the end of the year how much did I make on that $10,000. I mean how much did I really make. That means I have dedcut commissions and fees. It doesn’t matter if I had 80% cash the whole year or whether I was fully invested., It doesn’t matter whether I made all my gains from dividends or capital gains after taxes, it only matters how I am able to profit from all capital I have at my disposal in a real way then compare that to inflation. Since we have been in a low inflation lately the last has been much less important. Although I expect to be MUCH more important in their near future.

Back to Motley Fool. I have posted their service returns list for today below. At the bottom you will see a little note called “How Performance is calculated”, that I am convinced very few people actually read. I have included the unabridged text at the end of this posting, in case you would like to peruse it further. I will admit that I may have misunderstood something in their disclaimer. And if someone from the Fool sends me an email or comment, I will correct whatever error I have made in the body of my post. My goal is to be accurate.

Motley Fool Returns 2-27-11

Here is what I take away from the Fool disclosure:

1) Currently the Fool changes how they calculate their returns, depending on the service. That doesn’t make any sense. For example on the Rule Breakers service they exclude dividends from both the S & P 500 and their Rate of return calculation. For the Dividend Investor, unsurprisingly they includes Dividends for both. The Fool does say they are implementing a time weighted rate of return formula. All rates of return should be simple to understand, and reflect the total return of a portfolio for a specified period of time.

2) They don’t measure cash. “The total return is calculated using a time-weighted rate-of-return formula” after they use a simple rate of return for each individual stock, is how the Fool currently measure returns on their “Real Money” portfolios. This is overly complicated and inflates the returns since cash is not taken into account. The amount a portfolio has in cash is important to Total returns. Cash is an asset and in times of uncertainty, a great one to have in abundance. But having a large cash position will keep your returns down when the market is rising. For example in my 80-20 portfolio, I had only one stock traded in the last year. I made more than 50% on that  investment, but my total return was only 5% because, I was in cash most of the year for the entire portfolio. It doesn’t matter how right you are if you are only right once a year, with a small portion of a portfolio.

3) Some of their services aren’t real money, only theoretical. There has been a lot of research showing that while some ideas work great in theory, once you begin investing, the returns are significantly lower. My 80-20 portfolio is real money, and used some good theory like the Piotrsoski F-score and discounted NCAV value as it’s basis. But cash doesn’t earn anything these days, so my theoretical returns were fantastic, but my real returns were worse than the S & P 500.

4) The Fool’s record isn’t great. Even if you buy that you must compare to a benchmark their services haven’t by and large done well. Of the nine services they list, four performed worse or the same as their benchmark. But two out of three of their real money portfolios are performing worse than the S & P 500. Remember my comment about indexing. Perhaps there should be some consideration of that at the Fool.

My purpose isn’t to pick on the Motley Fool. I haven’t canceled my Hidden Gems service even though it was one of the worst relative performers listed. Why? Because I don’t follow everything they say. Nor should you. The only suggestion of theirs I have followed I made nearly 50% on in less than six months.

My purpose is to make sure you have your eyes open. When talking about what the returns are on your portfolio make sure they are real, not theorectical and that they include the trade off from capital gains and dividends, trading costs and the cost holding a lot of cash.

The complete Text of the:

The Motley Fool Investment Return Calculations Disclosures

Related Posts:

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• 80-20 Investing – the Portfolio
• Great Value Investing Strategies – Piotroski’s F-score Investing
• Value Investing Criteria that Works- Low Price to Free Cash Flow (FCF)
• Warren Buffett’s advice in a Crisis

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I first learned about this concept when reading Nassim Taleb’s book The Black Swan. He called confirmation bias “naive empiricism”. He said, “You take past instances that corroborate your theories and you treat them as evidence.” Further he writes, “I am saying that a series of corroborative facts is not necessarily evidence. Seeing white swans does not confirm the nonexistence of black swans.” He cites a study by P.C. Wason. In the experiment subjects were given a three number sequence of 2,4,6 and asked what rule would generate this sequence. “Their method of guessing was to produce other three-number sequences, to which the experimenter would respond “yes” or “no” depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule.” The problem is that most people will say something like 8,10,12. And the answer would be yes. After a couple of confirming examples you would announce that the rule was add 2 to the number before it, in succession. But the correct answer is actually any ascending numbers. I failed this example when I read it one of James Montier’s writings when he posed the question to the reader. I was reading about the problem and still fell for it.

How to prevent confirmation bias in our approach to investing?  Taleb directs us back to Karl Popper and his concept of “falsification.” We should attempt to prove false the ideas we are using. Again Taleb, “We can get closer to the truth by negative instances, not by verification!“  Popper, Taleb says leads the way out of our darkness, he “…introduced the mechanism of conjectures and refutations, which works as follows: you formulate a (bold) conjecture and you start looking for the observation that would prove you wrong. This is the alternative to our search for confirmatory instances. If you think the task is easy, you will be disappointed—few humans have a natural ability to do this.” In the Wason study, the way to figure out the proper rule would have been to submit numbers that declined, alternated, etc. To prove what the actual rule was by ruling out as many of the opposites as possible. It is only by figuring out what doesn’t work that you figure out what does.

The interesting idea to ponder is that if you are naturally a contrarian, like I am, you will be instinctively drawn to contrarian investing ideas, like value investing.  These ideas make more sense to me, than say momentum investing. But, am I really just looking for investing ideas that confirm my pre-existing biases? Perhaps.

It may also be why, even though I consider myself a value investor, I have not felt compelled to be bound by some rules that seem to appear in the blogsphere. Investing is ultimately a path, not a destination, this is just another pot hole to avoid.

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• Value Investing Ideas – Companies Passing my Custom Screens
• Warren Buffett’s advice in a Crisis
• Best Value Investing Screeners
• Real Returns are the only Returns that Matter

Today as the market dropped over 2%, HAST dropped over 17% to exactly the price sold at last week. Regret comes and goes. I have moved on to other  investment prospects.

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Also, remember that this profit in HAST is  only a 5.7% increase in the 80-20 portfolio. Now obviously if I could make 5% a month, every month I would be quite, pleased. But I don’t have those kind of expectations.

Disclosure: I have no current positions in HAST.

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I do not recommend purchasing this stock anymore, since it has appreciated so much in the past two weeks. In fact it has come very close to my selling point. I did not get my order filled or I would have sold it today.

Here is why I purchased this stock

1. Piotroski F-score of 9 (out of a possible 9)

2. Net Current Asset Value of approximately $4.54/share (so, price was just under Net Current Asset Value.

3. Negative Asset Growth.

4. Altman Z score for non-Manufacturing companies 3.77

5. Price to Book .59

Strategy: Put in a limit order when it crosses 50% gain again, which it did earlier today, but my sell order did not get filled.

Disclosure: As of this posting I own 110 shares of HAST. I do not recommending buying them right now.

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