Among the very most successful stock investing strategies of the year has been one focused on companies selling cheap but with strong book values. The strategy isn’t the brain child of Wall Street legends. It’s one developed by someone you may well have never heard of, a reserved Stanford accounting professor named Joseph Piotroski. In a paper published in 2000 by the Journal of Accounting Research Piotroski outlined the filters used to achieve 23 percent annual returns between 1976 and 1996. Piotroski’s ideas were compelling enough to attract the attention of John Reese, founder and CEO of Validea and Validea Capital Management, (pictured). Reese has spent the last 15 years studying history’s best investors and then building investment strategies based on that research. Among his “gurus”: Warren Buffett, Peter Lynch, and Ben Graham. So far this year, Piotroski’s method has topped those three, and the rest of Reese’s portfolios.
In this guest post, updating an earlier piece on his blog The Guru Investor, Reese explains the Piotroski strategy and offers some stocks that fit the bill today.
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 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 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. 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.
Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market, though with some big ups and downs. Over its first four-and-a-half years or so, it was more than five times ahead of the S&P 500. It was hit hard — like the rest of the market — in 2008, however, falling more than 37%, and it didn’t bounce back much in 2009, gaining just 6.8%.
This year, however, it’s up 41.6%, making it my best performer year-to-date. That means it’s up 62.1% since inception, a period in which the S&P 500 has risen 3.7%.
Let’s take a look at how Piotroski’s approach, and the model I base off of it, work.
Diving into The Balance Sheet
Piotroski 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.
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.
The harder part is determining whether investors are avoiding a high-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:
- Return on assets and cash flow from operations, both of which should be positive.
- Cash from operations that is greater than net income. (Such companies are making money because of their business — not because of accounting changes, lawsuits, or other one-time gains.)
- Improving fundamental performance (including rising return on assets).
- Declining long-term debt-asset ratio.
- Increasing current ratio (current assets/current liabilities).
- Rising gross margin.
- Increasing asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns.
As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks that rate high enough to make it into its 10-stock portfolio:
NASDAQ OMX Group (NDAQ)
Companhia de Saneamento Basico ADR (SBS)
Owens Corning (OC)
Chiquita Brands International (CQB)
Flagstone Reinsurance Holdings SA (FSR)
PHH Corporation (PHH)
Echostar Corporation (SATS)
The Hanover Insurance Group (THG)
Telecom Italia ADR (TI)
Meadowbrook Insurance Group (MIG)