I recommend reading this along with Joseph Piotroski’s original paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers,” for a full description of the tests and the return characteristics.
Piotroski constructed his model not through the result of endless backtesting, but by a selection of characteristics that he (and previous research) had identified as improving expected equity performance. It is important to note the Piotroski model is not dynamic and was not optimized using historical data. One of its main qualities is its simplicity.
The F-Score is made up from a group of binary financial tests based on profitability, leverage, liquidity and operating efficiency. The higher the number of tests a stock passes, the better an investment that stock is supposed to be. If a stock passes all tests, achieving an F-score of 9, then we assume that stock would be an excellent investment. On the other hand, a stock with a score of 0 or 1 should be avoided.
The nine tests:
- Return on assets is positive.
- Operating cash flow is positive
- Change in return on assets is positive.
- Accruals are negative.
- Change in leverage is negative.
- Change in liquidity is positive.
- Change in finance is negative.
- Change in margin is positive.
- Change in asset turnover is positive.
Profitability
A lot of value stocks are “cheap” because of a deterioration in their business model, so they become less profitable than they once were or loss-making and, therefore, the drop in the stock price just reflects that. Avoiding an investment in a company whose earnings-generating power is poor seems sensible.
Piotroski uses three profitability measures:
- Return on assets
- Operating cash flow
- Change in ROA
ROA is calculated as net income before extraordinary items divided by total assets, while CFO is cash flow from operations divided by total assets. If ROA is positive, the company is profitable, so it scores one point, otherwise it gets zero. The same goes for CFO. Improving profitability is also something we want, so change in ROA is simply the year-on-year change in ROA where, if the current year’s ROA is greater than in the previous year, the company is awarded a score of one.
Generating profit growth by selling more (rather than through financial engineering) is preferable and much research has advocated using accruals in the investment process. The F-Score compares net income before extraordinary items against cash flow from operations. So, the fourth item is if the change in CFO is greater than the change in ROA, then the stock scores one, otherwise it gets zero.
Leverage, liquidity and source of funds
Avoiding balance sheet weakness is clearly very important. Some stocks trading at multiyear lows might have excellent long-term opportunities, but quite of a lot of them will not and, in my view, staying away from these weak stocks seems sensible, even during a period of “dash for trash” – often this price action is just a dead cat bounce.
Piotroski shows us three metrics that can help us avoid stocks getting into financial difficulty.
The first of these elements, change in leverage, is the annual change in a company’s leverage as measured by the year-on-year change in the ratio of long-term debt to total assets. The ability to self-finance a business is obviously important and, often, totally forgotten at the top of an economic cycle.
How about short-term financing? Liquidity concerns the short-term financing of the company and is measured as the annual change in the current ratio (the ratio of current assets to current liabilities). A rise in the current ratio shows an ability to service debt costs, while a decline could mean, potentially, short-term funding problems.
Issuing equity ultimately costs existing shareholders, either in cash or dilution. A deeply discounted rights issue at depressed prices is particularly annoying. In the F-Score, those stocks which issue equity, which we measure as the year-on-year change in shares, also known as change in finance - score zero and those that do not score one.
Operating efficiency
Piotroski includes two simple metrics for a stock’s operating performance – an increase in operating margin, referred to as change in margin (measured as the year-on-year change in the gross operating margin), and the annual change in the asset turnover. The change in asset turnover shows how much revenue has increased relative to the size of the asset base. Increasing revenue at a greater speed to the change in asset indicates that a compnay is generating more business from existing assets rather than simply growing revenue through acquisitions.
Investment implications
There is strong evidence that the greater the quality of a stock, as judged by its F-Score, the better its long-term return. We can consider scores of 7, 8 or 9 to be very good. Conversely, staying away from stocks with low F-Scores like 0, 1 or 2 would also appear to be wise.
In the FTSE All-Share Index, there are only two stocks that score a perfect 9 right now: Anglo-Eastern Plantations PLC (LSE:AEP, Financial) and Ferrexpo PLC (LSE:FXPO, Financial).
