Investing in the stock market is risky, but you can tilt the odds in your favour with a strategy based on the F-Score.
Many stock picking strategies have been suggested, but my favourite uses the work of Joseph Piotroski. The Piotroski F-Score identifies healthy stocks with data you can easily find from company financial reports.
Why am I so smitten by the work of this man and the F-Score? Well, the American Association of Individual Investors (AAII) benchmarks the performance of over 60 investment strategies and styles. The strategies include techniques that rely on momentum, value, growth and more. For the year to December 2010, the AAII found that his strategy gave a return of 139%. Not only that, in the financial turmoil of 2008, his strategy was only out of 53 that delivered positive returns.
Let’s take a closer look at his winning strategy.
In 2000, Piotroski published a paper called “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”. He gave 9 tests for high-performing stocks. These tests use data from company financial reports, and measure the health of a company.
Each test scores 1 point if the stock passes, or 0 otherwise.
1. Net Income. Positive net income (from the most recent financial statement) scores 1.
2. Operating cash flow. This is a measure of profitability. Positive values score 1
3. Return on assets. This is the net profit divided by the assets. If the return on assets has increased year-on-year, then score 1
4. Earnings quality. If the operating cash flow is greater than net income, score 1
Leverage &Liquidity (i.e. Capital Structure and Debt Service)
5. Decrease in liquidity. If the long term debt divided by the average assets is lower this year than the prior year, then score 1
6. Increase in liquidity. The Current Ratio is the current assets divided by the current liabilities. If this year’s figure is greater than last year, score 1
7. Absence of dilution. If no new shares were issued in most recent year, then score 1
8. Gross Margin. Has the competitive position improved? If gross margin this year is greater than last year, then score 1
9. Asset Turnover. If asset turnover this year is greater than asset turnover last year, then score 1.
After summing the results for all 9 tests, stocks with higher scores are better investments. Piotroski’s stock-picking strategy involves picking the cheapest stocks in the market, and buying those with an F-Score of 8 or 9.
Does it Work?
Most backtesting has taken place in the US, but the results are very compelling. I’ve already mentioned that the American Association of Individual Investors found that the F-Score would have helped investors steer the rock markets of 2008 to 2010. Piotroski’s own historical tests showed his strategy lifted the average yearly return of a value (or high book to market) investor by 7.5%
Moreover, Piotroski found that stocks that score less than two points were five times more likely to be financially distressed, often to the point of bankruptcy. This in itself makes the F-Score a useful addition to the Beneish M-Score.
Independent tests by the Societe General stock research team demonstrated that stocks with high F-Scores returned more than the market four years out of five. They also showed that stocks with F-Scores lower than 3 underperformed the market.
When Should Investors use the F-Score?
Piotroski emphasized that the F-Score “does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms”, but is just one of many ways of filtering out badly run firms in competitive industries.
I tend to use the F-Score for companies with a recent run of bad results but which now show tentative signs of recovery. Additionally, it should not be used in isolation, but as one of several methods investors use to pick stocks.