The Piotroski Score Will Make You a Better Investor
2017-08-25 - by Wilton - 268 views
In 2000, Joseph Piotriski published a paper called “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” In this paper, he outlines a methodology, now known as the Piotroski Score, for increasing one’s investment returns by closely examining the historical financial information of companies.
Now, there are many articles available that describe what the Piotroski score is, and since there are mechanisms for calculating it automatically, we will cover it only briefly. In this article, we will dig into the underlying investment strategy and explain how it works.
Value investing is a well-known investing strategy that is followed by almost all of the famous investors. Benjamin Graham, of course, is the father of it, and Warren Buffet is one of his most famous disciples. Value investing, as the name implies, is focused on finding “cheap” companies – that is, companies who are trading at a low market price relative to their actual value. Price is not value. The trick is determining the underlying value.
One measure of value is book value. Book value is an accounting measure that represents the amount of money a company would have if it went out of business immediately. The book value is almost always less than the market value of a company, since companies are expected to have future earnings.
If you divide the market value by the book value, you get Price/Book, which is the ratio usually used for this comparison. When Price/Book = 1, the market believes the accounting value is accurate, and when Price/Book < 1, the market thinks the accounting value is too high. (Note: In Piotroski’s paper, he uses the term “BM” which is Book/Market, the reciprocal of Price/Book”.)
So, one great way to find undervalued companies is to find companies with a low Price/Book ratio. The problem with this approach is that there’s usually a very good reason why this ratio is low. Generally speaking, companies with a low Price/Book ratio are distressed. Directly after the financial crisis, for example, most banks had Price/Book values of less than one – primarily because of those toxic assets nobody could figure out.
The trick is to find companies that were distressed, but are now recovering, before the rest of the market finds them. If only there was some mechanism for determining the actual financial health of a company…
As you probably figured, the Piotroski score does just that. The score itself is a kind of ranking that ranges from zero to nine (nine being good). The number is the result of nine “signals” that measure three areas of financial condition: profitability, financial leverage, and operating efficiency. Embedded in these measures, however, is the concept of change. For example, if the company is making more cash this year than last, then it gets a point. In other words, companies with higher Piotroski scores are not just healthy, they are improving.
With that in mind, it becomes natural to think that combining the Price/Book and Piotroski Score measures in a stock screen could lead to some great finds.
In fact, Piotroski found that “an investment strategy that buys expected winners and shorts expected losers generates a 23% annual return between 1976 and 1996…” The American Association of Independent Investors (AAII) also reports phenomenal results from a Piotroski-based investment strategy.
So, the overall strategy is to find companies with a low Price/Book value but a high Piotroski score. Of course, there is a lot of room in here to get lost, but Piotroski offered one other excellent tidbit.
He stated that the companies with the best returns were smaller, thinly traded companies with no analyst coverage. The reason these types of companies tend to do better is because of the information gap – large companies that have a lot of analysts are going to have their financials pored over pretty regularly, so the chances of finding a mispricing will be much smaller. On the other hand, if one can find a small distressed company that is on the mend, it could represent an excellent opportunity.
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Wilton - 2017-10-11