Piotroski value hunt

One of the frustrations I have with running UK-focused Piotroski screens (I run a Piotroski screen in January each year) is that the definition of what constitutes a 'value' stock gives the screen's results a rather narrow focus. In his 2000 paper 'Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers', Mr Piotroski looked at companies with low price-to-book values (P/BV). Despite my frustrations (more of that later) there's no arguing that this is a very effective method of trying to identify cheap stocks.

There are two key strands of logic as to why investors can profit from focusing on P/BV. Firstly, if a company that is lowly valued compared with its book value (also known as net asset value) is in such a poor state that it needs to be sold or broken up, then there may be value in its asset base that can be unlocked for shareholders. The more optimistic take on low P/BV stocks is that they are synonymous with companies that have seen their asset bases become temporarily unproductive and unappreciated by the market, but have the potential to start generating better returns from those assets in the future.

So there clearly is a good underpinning for looking at P/BV as a way to spot value and Mr Piotroski's own study found that using low P/BV along with high F-Scores produced a 23 per cent annual return between 1976 and 1996, on a long-short approach.

But back to my frustration with the classic Piotroski screen. The problem for me is that by only using P/BV as a measure of value, the screen inevitably hones in on certain types of companies: those that are asset rich by their nature. With this week's screen I am aiming to find stocks with a high F-Score but that qualify as 'cheap' against one of a number of different valuation metrics as well as P/BV.

Not only should this mean the screen results provide more types of investment opportunities, the screen should provide a greater number of results, which is arguably a benefit given the high volatility of the kind of value/recovery stocks that the screen is so good at identifying. I've also tried to broaden the focus of this F-Score screen by separately screening the FTSE All-Share, the FTSE All Small and the FTSE Aim All-Share. This is aimed at getting more positive results from shares in larger companies. Indeed, the higher risks associated with smaller companies generally means they tend to command lower ratings, so small-cap shares tend to dominate the results of the screen when the whole market is screened.

Finding value

As well as P/BV, I am using four other valuation metrics with this screen - essentially a selection of my personal favourite valuation ratios. For a company to be considered 'cheap' against one of these ratios it must be among the lowest valued quarter of all stocks screened on that particular metric. The four other value measures I've screened against are:

Dividend yield (DY): A good dividend is generally underpinned by a company generating sufficient earnings and cash flows to support it, as such a high yield can be a broad indicator of value. What's more, a good income from a share is very nice to have in its own right.

Enterprise-value-to-sales ratio (EV/sales): I generally regard this as a measure of contrarian value. The principle of buying low EV/sales stocks is that a company's profits may be temporarily depressed but it still has sales, which leaves it with the scope to rebuild its profitability, and thereby catch the attention of our earnings-obsessed market. Using enterprise value (EV) in the formula helps take account of the level of cash and debt held by companies. EV is calculated by adding debt onto a company's market capitalisation and subtracting cash.

Enterprise-value-to-free-cash-flow (EV/FCF): Many investors believe that focusing on cash gives a better idea of what value is on offer than the market's preoccupation of focusing on earnings. That's because reported cash flows are not open to the same degree of manipulation as reported earnings. In fact, every balance sheet write-down and big exceptional charge should serve as a reminder to how easy it is for companies to overstate earnings, whether innocently or intentionally. This valuation ratio focuses on free cash flow which is an approximation of how much cash a business would generate if it was simply funding the bear minimum of investment needed to get by.

Genuine value (GV): This is the souped-up price-to-earnings growth ratio that I use for many of the screens in this column. As well as looking at how a company's shares are priced compared with historic profits and comparing that with the growth rate, the ratio also attempts to take account of a stock's dividend yield and the amount of debt and cash a company holds. The formula is:

Enterprise-value-to-operating-profit ratio/average forecast earnings growth for the next two financial years plus dividend yield

or

(EV/Ebit)/(average (EPS gr+1 and EPS gr+2) + DY)

The F-Score

The F-Score focuses on nine fundamental factors. Many of the tests are also concerned with improving fundamentals and checking that fundamentals have been improved by the company's own efforts rather than outside financing.

■ Positive profit after tax, excluding exceptional items.

■ Positive cash from operations.

■ Profits after tax excluding exceptional items are up on last year, which Professor Piotroski highlights as being of particular importance as a signal that a company may be in recovery mode and in the process of re-rating.

■ Cash from operations is higher than profit after tax, excluding exceptional items, which indicates an ability to convert accounting profit into actual cash.

■ Gearing (net debt as a percentage of net assets) is down on the preceding year, which suggests that the company has not had to look for external sources of finance.

■ The current ratio (current assets divided by current liabilities) is up on the preceding year, which suggests that the company's ability to service upcoming financial obligations is improving.

■ No new shares issued over the last year, which again suggests that the company has not had to look for external sources of finance.

■ Gross margins have risen in the last year.

■ Improving capital turn (turnover as a proportion of net assets), which suggest greater productivity.

The stocks that passed the screen are listed in the three tables below, according to their index. Where a stock is both a member of the FTSE All-Share and the All Small, they appear in the All-Share table. Details are also given of the valuation measure the shares qualify on. Only Air Partner and Peel Hotels achieved an F-Score of nine, all the other stocks listed scored eight.

The All-Share

Source: S&P Capital IQ

The All Small

Aim