How to select good value stocks the Piotroski way
Just recently, we discussed in this column titled “Is it safe to invest in value stocks?” that low price-to-book (P/B) stocks are not necessarily the cheapest in the market. This is because most value stocks tend to be financially distressed with poor growth prospects, which make them very risky investments.
But despite this, there are still unique opportunities to make money from low-valued stocks by simply focusing on fundamentally sound companies. According to Joseph Piotroski of the University of Chicago, there is a way to select low P/B stocks with good fundamentals by following a scoring system known as the Piotroski F-score.
This system, which aims to separate winners from losers, identifies potential stocks by answering nine questions, which are classified according to profitability, capital structure and operating efficiency.
Each question is given either one point for a “yes” or 0 point for a “no,” with the stock getting eight or nine points as the most promising to recover, while those with three points and below are the ones likely to underperform. The Piotroski F-score starts with the most basic question: Does the business make money? If the company is profitable, did it grow from last year with a higher return on assets ratio?
Every investor wants to see growth in earnings but an increase in earnings without an increase in cash flow can be a red flag because there are companies that manipulate their earnings through creative accounting without generating real cash flows. The next questions to ask are: Does the company generate positive operating cash flows? Are they higher than the net
income? Since most value stocks are financially challenged, we want to know which ones have shown signs of improving capital structure with these questions:Is the company more liquid this year with higher current ratio? If it is increasing its liquidity position, does it have lower long-term debt from last year? Did it refrain from raising cash by issuing new shares? Companies that can generate adequate internal funding to improve their financial condition have better chance of lowering their financial risks.
Profitability and cash flows are two important factors in growing a business. Evaluating the operating efficiency of a company with these two questions can help identify which ones are likely to sustain its growth in their earnings.
Is the company more productive this year with higher sales-to-assets ratio? If high productivity means lower costs, does the company have higher gross margin from last year?If we apply this system for low P/B stocks, we will find that the Piotroski F-score seems more effective when the market is trending up.
For example, if we screened stocks by the end of 2015 following this method, we would find that only Megawide, which was trading slightly below its book value then, had a score of 8 points. True enough, in the year that followed, the stock generated a huge return of 138 percent. The same thing happened in 2016 when only Ginebra and Phoenix Petroleum were the only below book value stocks that received a eight points.
Given the strong market in 2017, both stocks made fantastic returns that year with Ginebra ending the year with 111 percent, while Phoenix with 130 percent gain.
But last year, as the market was generally nontrending, Ionics, which had a perfect score of nine points, ended the year with a disappointing loss of 28 percent.
This year, three below book stocks, A Soriano, Belle and Pepsi, made it to the top list, but given bearish market outlook, will they also disappoint?Despite its track record of success, the Piotroski F-score is not a foolproof system to select winners. As it is based on past financials, it will be best to apply the system along with other tools to enhance your value investing strategy. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 82nd batch of RFP program this March 2020. To register, email [email protected] or text at 0917-9689774.
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