A Simple Accounting Strategy With Extraordinary Returns

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joseph Piotroski-inspired strategy. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Piotroski-based investment strategy.

Taken from the October 10, 2014 issue of The Validea Hot List

Guru Spotlight: Joseph Piotroski

If you haven’t heard of Joseph Piotroski, you’re not alone. He’s probably the least well-known of the investment “gurus” who inspired my strategies. Actually, he’s not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don’t need to be a smooth-talking Wall Street hotshot 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). These are stocks that have very low expectations.

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 percentage points annually. Buying the high book/market firms that passed his strategy and shorting those that didn’t would have produced an impressive 23% average annual return from 1976 and 1996.

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Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has been my most volatile strategy. It has a beta of 1.34, meaning it has been 34% more volatile than the broader market. At times, it has been far ahead of the S&P 500, but right now it’s coming off a few rough years that have put it at the bottom of my 10-stock, monthly rebalanced Guru Strategy portfolios. Since inception, it has returned 45.4% versus 71.6% for the S&P. It has lagged the index in each of the last three years, but keep in mind that back in 2010, after a couple of mediocre years, the deep value strategy roared back, gaining more than 55% — quadrupling the S&P and more than doubling the gains of my next best individual guru portfolio. Volatility is to be expected from a deep value strategy that often focuses on small caps, so I really wouldn’t be surprised if the Piotroski model puts up some big bounce-back numbers over the next couple years.

It’s also worth noting that when rebalanced annually — the approach Piotroski took in his paper — the Piotroski approach has been one of my best performers, producing 8.1% annualized returns vs. 5.2% for the S&P.

Let’s take a look at how Piotroski’s approach, and the model I base on it, work.

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, so that’s the figure I use.

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.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business — not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski’s 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. Looking at how a company’s fundamentals had been changing allowed him to not only get an idea of the firm’s financial position, but also of whether that position was improving or declining.

Among the other “change” criteria my Piotroski-based model examines are the long-term debt/assets ratio, which should be steady or declining; the current ratio (current assets/current liabilities), which should be steady or increasing; gross margin, which should be steady or 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 steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are the stocks currently in its 10-stock, monthly rebalanced portfolio.

Owens Corning (OC)
Era Group Inc. (ERA)
Transocean Ltd. (RIG)
GulfMark Offshore, Inc. (GLF)
Vodafone Group Plc (VOD)
BHP Billiton plc (BBL)
United Microelectronics Corp. (UMC)
Marchex, Inc. (MCHX)
Companhia Paranaense de Energia (ELP)
AGCO Corporation (AGCO)