Many studies have shown that low P/B stocks outperform high P/B stocks.
Roger Ibbotson, Professor in the Practice of Finance at Yale School of Management and President of Ibbotson Associates, Inc., a consulting firm specializing in economics, investments and finance, in Decile Portfolios of the New York Stock Exchange, 1967 - 1984, Working Paper, Yale School of Management, 1986, studied the relationship between stock price as a percentage of book value and investment returns. He split all the stocks traded on the NYSE into ten deciles. Decile one contained the bottom tenth of the stocks with the lowest P/B ratios and decile 10 contained the top tenth of the stocks with the highest P/B ratios. The test was run once a year for 18 years and decile one returned 14.4% and decile 10 returned 6%.
Piotroski took the idea that a large portfolio of the lowest P/B stocks would outperform the market and added to it. Piotroski knew that many of these stocks were financially distressed and would turn out to be duds and that they deserved to be trading far below book value.
So he developed nine criteria that when combined with a large number of low P/B stocks, would help eliminate the financially distressed companies and would keep the strong ones. He reports that his screen produced a return of 23%.
Here are his criteria that he applies to the low P/B stocks:
Operating cash flow: Piotroski considers cash flow the real earnings gauge. Passes if full-year cash flow is positive.
Return on assets: Piotroski wants to see increasing profitability. Passes if full-year ROA exceeds prior-year ROA.
Quality of earnings: Cash flow usually exceeds net income because income is typically reduced by non-cash charges such as depreciation. If it's not Piotroski says that's a
bad signal about future profitability and returns. Passes if full-year operating cash flow exceeds net income.
Long-term debt vs. assets: Piotroski prefers companies that are cutting debt. Passes if the full-year ratio of long-term debt to assets is down from year-ago.
Current ratio: Piotroski sees CR as a way to gauge if liquidity is improving which is a good signal about the companies ability to service its debt. Passes if the CR increases from the prior year.
Shares outstanding: Piotroski penalizes companies that sell stock to raise cash.
"Financially distressed firms that raise external capital could be signaling their inability to
generate sufficient internal funds to service future obligations." Passes if the current number of shares outstanding is no greater than the year-ago figure.
Gross margin: Increasing gross margins often signal that a company's costs are decreasing or product selling prices are increasing. Passes if full-year GM exceeds the prior-year GM.
"An improvement in asset turnover signifies greater productivity from the asset base. Such an improvement can arise from more efficient operations (fewer assets generating the same levels of sales) or an increase in sales (which could also signify improved market conditions for the firm’s products)." Passes if current year asset turnover ratio is greater then last year's asset turnover ratio.
Value Investing: The Use of Historical Financial Statement Information
to Separate Winners from Losers By Joseph Piotroski
Sunday, October 14, 2007
Sunday, October 7, 2007
The Heilbrunn Center for Graham & Dodd Investing did an excellent job interviewing Richard Pzena. The interview is from December 2006. Joel Greenblatt calls him the smartest man he knows and I totally agree. This is something worth reading.
Link to Interview
Link to Interview