Over the years, the financial world has seen its share of great investing strategists: Benjamin Graham, Warren Buffett, Peter Lynch, Joseph Piotroski --
Wait -- Joseph Who?
If you haven't heard of Piotroski, you're far from alone. Of all the excellent investment minds upon whom I base my Guru Strategy computer models, Piotroski is probably the least known. But while he lacks the fame and reputation of investors like Buffett and Lynch, his contribution to the investing world has been quite significant.
In 2000, Piotroski, a University of Chicago accounting professor, authored a highly regarded academic paper on stock investing that turned quite a few heads on Wall Street. His research focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares).
Quite often, such firms have high book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.
Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percent annually over high book/market stocks chosen without his special criteria. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23 percent average annual return from 1976 and 1996.
My Piotroski-based method is a computer model that mimics the strategy detailed in Piotroski's paper. Since its inception, almost four years ago, a portfolio of stocks scoring highest on this method has increased 71 percent, more than doubling the S&P 500's 28.1 percent return. Let's take a look at how my Piotroski-based model works, and at a few stocks that currently make the grade.
Finding winners among the market's unloved
Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff (whom I wrote about a few weeks ago) used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.
The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use. As an example, let's look at NACCO Industries (NYSE:NC), an interesting firm that not only makes kitchen appliances and lift trucks, but also is involved in coal mining. Currently, to be in the top 20 percent of the market, a stock's book/market ratio must be 0.93 or higher; NACCO's book/market ratio of 1.01 makes the grade, showing that it hasn't been the most popular stock lately.
Now comes the harder part: determining whether investors are avoiding NACCO because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The first step is a measure I've discussed before when talking about Peter Lynch and Warren Buffett: the return on assets figure, which shows how profitable a company is. To pass my Piotroski-based method, a company's ROA for the most recent year must be positive. NACCO's current ROA is 3.48 percent. That's an indication that the company is profitable, which of course is a good sign.
It's not good enough for a company to be profitable, however. A troubled firm's return on assets could be rapidly dwindling, but still positive. The next part of my Piotroski-based model is thus to make sure the stock's return on assets for the most recent year is higher than it was the previous year. Two years ago, NACCO's ROA was 2.22 percent, below the most recent year's 3.48 percent figure. It looks like profitability is increasing, another good sign.
Another profitability measure Piotroski used was cash flow from operations. Companies with negative cash flows from operations are burning cash, not a good sign. A firm must thus have a positive cash flow from operations for the current year. Again NACCO makes the grade, with a cash flow from operations of more than $173 million in the most recent year. It's looking more and more like this is a good company simply being overlooked by Wall Street.
Piotroski also thought that good companies had cash from operations that was greater than net income. Last year, NACCO's cash from operations was just over $173 million while its net income was $75.2 million. It passes the test.
Like other value investors I've discussed, Piotroski also didn't want companies to be hamstrung by debt. His study focused on firms that had maintained or decreased their long-term debt/assets ratios in the most recent year. Last year, NACCO's long-term debt/assets ratio was 0.17, down from 0.19 the year before, passing this test.
Looking for improvement
Several of Piotroski's other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. Among them are:
Change in current ratio: The firm's current ratio (current assets/current liabilities) for the most recent fiscal year must be greater than it was in the previous year. NACCO's current ratio last year was 1.54, up from 1.52 the previous year, passing this test.
Change in shares outstanding: Companies issue new stock when they are trying to raise capital, which Piotroski saw as a sign that they can't generate enough internal cash to fund the business. An increase in shares outstanding in the most recent fiscal year is a bad sign in this method. NACCO had 6.6 million shares outstanding last year, the same as it had in the previous year, good enough to make the grade.
Change in gross margin: It's a good sign when a company is expanding its margin, because on average it is making more on each product it sells. This method requires that gross margin for the most recent fiscal year be greater than the previous year. Again, NACCO passes the test. Its gross margin last year was 17 percent, up from 16 percent the previous year.
Change in asset turnover: Asset turnover basically measures a company's sales in relation to the assets it owns. To pass this method, a company must have increased its asset turnover in the most recent year. NACCO's asset turnover was 1.55 last year, up from 1.51 in the previous year, yet another good sign.
NACCO thus passes every one of my Piotroski-based financial soundness tests. It appears to be a good bet that this high book/market company is being overlooked by investors despite its solid financials. That's just the kind of firm that Piotroski found to produce very good returns.
Think small
Another reason NACCO fits with Piotroski's research is its small market capitalization ($824 million). Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts. Small stocks are more likely to fly under the radar of analysts and investors, so you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks. Currently, there are just 11 stocks in the market that get approval from my Piotroski-based model, and 10 of them are small caps. Keeping in mind that any small caps are susceptible to greater volatility than larger stocks, here's a look at a couple that make the grade:
Spherion Corporation (NYSE:SFN): Spherion, a Florida-based staffing and recruiting company that has a $408 million market cap, has a 1.20 book/market ratio but very strong fundamentals. Its return on assets is 3.19 percent, it has no long-term debt, and its gross margin increased from 22 percent to 24 percent in the most recent year.
Natuzzi S.p.A. (NYSE:NTZ): Based in Italy, Natuzzi makes a variety of leather-upholstered furniture and furnishings accessories. The $252 million market-cap firm has a 2.63 book/market ratio, easily putting it in the top 20 percent of the market. But it appears quite financially sound, with a 2.15 percent return on assets rate, no long-term debt, and a current ratio of 3.06.
The L.S. Starrett Company (NYSE:SCX): This $112 million market-cap firm makes several types of industrial, professional, and consumer products, including saw blades, electronic gauges, and measuring tools. Its book/market ratio, 1.61, indicates that the company is unloved by Wall Street, but its financials look good: Its return on assets is 2.4 percent, it has a 0.04 long-term debt/assets ratio, and its gross margin is 30 percent, up from 23 percent the previous year.
Like Piotroski himself, these stocks aren't particularly glamorous or headline-grabbing. But therein lies a critical stock market lesson: You don't need fancy strategies or a portfolio of high-flying, flashy stocks to make money in the market. While the end result of successful investing -- strong returns -- can be quite eye-catching, the path leading to those returns is often filled with pragmatism, common sense, and a disciplined, fundamental-based approach to stock picking.
Published by Globes [online], Israel business news - www.globes.co.il - on January 10, 2008