Unknown Investment Guru � Joseph Pioroski
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. He's probably the least well-known of the investment "gurus". Actually, he's not even a professional investor, but instead an accountant and college professor. 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, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hot-shot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge � just a straightforward assessment of a company's balance sheet.
His study turned quite a few heads on Wall Street. It 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 low 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. 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.
Diving into the Balance Sheet
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 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.
That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.
Several of Piotroski' other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting.
Among the other "change" criteria Piotroski examined were the long-term debt-asset ratio, which he wanted to be declining; the current ratio (current assets/current liabilities), which he wanted to be increasing; gross margin, which should be rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be increasing).
Piotroski Approach Criteria
Despite the differences in portfolio construction, the underlying variables that the strategy looks at are same. The approach begins by looking at bottom 20% of the market based on Price/Book ratio (this is the same as firms with high Book/Market ratios). Piotroski found that just buying low Price/Book stocks does not produce excess returns over the long term, however, because many low Price/Book companies are trading at a discount because they deserve to. Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. The 10 criteria are listed below.
- Book/market ratio
- Return on assets
- Change in return on assets
- Cash flow from operations
- Cash compared to net income
- Change in long-term debt/assets
- Change in current ratio
- Change in shares outstanding
- Change in gross margin
- Change in asset turnover
- Return on assets
- Change in return on assets
- Cash flow from operations
- Cash compared to net income
- Change in long-term debt/assets
- Change in current ratio
- Change in shares outstanding
- Change in gross margin
- Change in asset turnover
Examples
Few firms usually pass all of Piotroski-based model's strict criteria, and often they are very small stocks, some of which are too illiquid for most investors. But the Piotroski-inspired portfolio has found big winners among stocks that get scores of 90%, 80%, or even 70% from the model, and, right now, a number of stocks fall into that category. Let's see some examples of what types of stocks the Piotroski model currently likes:
Photronics, Inc. (PLAB): This Connecticut-based small-cap ($365 million) makes photomasks -- high precision photographic quartz plates containing microscopic images of electronic circuits -- that are used in the manufacture of semiconductors and flat panel displays.
Photronics gets a solid 80% score from my Piotroski-based model, thanks in part to its 1.22 book/market ratio. And, in its most recent fiscal year, the firm upped its return on assets from -7.75% to 3.25%, lowered its long-term debt/assets ratio from 17% to 11%, and increased its gross margin from 16% to 22%, all reasons the Piotroski model gives it high marks.
Audiovox Corporation (VOXX): This New York State-based consumer electronics firm owns such well-known brands as RCA and Energizer. It makes a wide variety of mobile electronics and consumer electronics and accessories, ranging from vehicle security and remote start systems to MP3 players and digital camcorders to headphones, speakers, and batteries.
Audiovox is a small stock ($171 million market cap), so it is likely to be more volatile than larger stocks. But the firm has taken in more than $570 million in sales over the past year, and it gets a solid 80% score from my Piotroski-based model. One big reason: Its impressive 2.17 book/market ratio. (Looked at another way, that means its shares are trading for less than half of book value.) The firm also posted a 4.14% return on assets in its most recent fiscal year, a sharp turnaround from -13.88% the prior year, and it kept its long-term debt/assets ratio steady at just 2%. Gross margin also improved to 19%, up from 17% the year before.
M&F Worldwide Corp. (MFW): M&F ($480 million market cap) is the parent of several businesses, including Harland Clarke Corp., which makes checks and check-related products, direct marketing, and contact center services; Harland Financial Solutions, which makes software for financial firms; and Scantron Corporation, which offers testing and assessment systems and data collection and analysis services. And then there's an intriguing fourth member of the group: Mafco Worldwide Corp. -- a world leader in the licorice -- that's right, licorice -- industry.
M&F shares surged early this week after a weekend article in Barron's was bullish on the stock, and then slid downward Friday. Its book/market ratio remains in the top 20% of the market, however, at 1.25. It also has the balance sheet and fundamentals to boot: Its return on assets (3.24%) almost doubled in its most recently reported fiscal year, while its current ratio rose to 1.63 (from 1.18) and its long-term debt/assets ratio fell to 62% (from 64%). Overall, the stock earns a 90% score from this approach.
AXIS Capital Holdings Limited (AXS): Headquartered in Bermuda, AXIS provides specialty insurance and treaty reinsurance across the world through operating subsidiaries and branch networks based in Bermuda, the U.S., Canada, the U.K, Ireland, Switzerland, Australia, and Singapore.
AXIS ($4.5 billion market cap) gets a 70% score from the Piotroski-based model. It has a book/market ratio of 1.22, which is in the market's top 20%, and in the most recently reported fiscal year it increased return on assets (2.65%, up from 2.15% the previous year) and had positive cash flow from operations (about $850 million). Its number of shares has also declined in recent years, which this model considers a good sign -- Piotroski found that an increasing number of shares outstanding might be a sign that a firm couldn't generate enough internal cash to fund its business.
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