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Risk it with 13 Piotroski picks

Following a tough 12 months for 2014's Piotroski picks, the screen has come up with a high-risk selection of 13 stocks for the new year, several of which have exposure to commodity prices and Russia
January 20, 2015

At the end of 2014, I was pleased to be able to sign off my year of stock screens with a real belter - the Have-it-All screen which delivered a 23 per cent total return compared with 5 from the FTSE All-Share. Unfortunately, 2015 starts with something of a body blow, a negative 7.1 per cent total return from the Piotroski screen compared with a 1 per cent positive return from the FTSE All Share. However, this underperformance is not perhaps as bad as it first appears.

When things go well, it tends to be human nature to bask unquestioningly in the glory of success, but when things go badly, the normal response is to start feebly scrambling around for excuses. Unfortunately, I can see this base psychology at work in my own reaction to the underperformance of the Piotroski picks over the last 12 months which has led me to find 'an excuse' for the screen. Normally, especially when it comes to investment, it is best to ignore the primal desire to find excuses. Aside from anything else, when it comes to stock screening, bouts of underperformance (sometimes very horrible ones) should be expected. What's more, one of the benefits of using a mechanical process in trying to identify investments is that it provides a healthy detachment from raw emotions. However, in this case I think the 'excuse' in question on not only offers a more favourable view of last year's underperformance (and as it happens a less favourable view of previous years' outperformance) but, more importantly, it presents an opportunity to get more out of the screen in the future.

 

Yes but, no but…

So, excuses time. The fact is, while I have always treated my Piotroski screen as a strategy to be judged against the FTSE All-Share, the reality is that it is actually more of an Aim and small cap screen. My intention when I chose the FTSE All-Share as a benchmark was not to be disingenuous, as I simply wanted a broad-based index to reflect the fact that the screen takes in every share on the stock market, including all Aim shares. However, smaller companies tend to make up the vast majority of the share picks when the screen is conducted in this way.

The dominance of smaller companies can be explained by the fact that small caps tend to have lower valuations than larger companies given that they are generally more risky. As the Piotroski screen is only interested in the lowest-valued quarter of shares based on the price-to-book ratio (P/BV), it is inevitable that this will normally give the screen a strong bias towards the market's small fry. Indeed, of the 12 stocks picked by last year's screen, 10 had market capitalisations of less than £500m, nine less than £200m and seven less than £100m. What's more, seven of the 12 stocks - more than half - came from the FTSE Aim All Shares.

Given this strong bias towards companies from the FTSE Small Cap and Aim, it seems more fitting to compare the screen's performance with these indicies than the large-cap dominated All-Share. On that basis, last year's undeniably poor return actually looks just passable when compared with a 50:50 split of the FTSE Small Cap and FTSE Aim All Share, which recorded an even larger negative total return of 8.7 per cent. It should be noted, though, that my performance figure for the screen does not account for bid-offer spreads, which can be a significant factor with small caps.

However, if I am going to look at last year's Piotroski result against the Small Cap and Aim indices, the same exercise needs to be applied to prior year results. The table below shows that this makes the outperformance achieved in 2012 and 2013 look less impressive than it did against the All-Share. Nevertheless, the Piotroski screen has still produced some very solid outperformance since I started running it in January 2012 boasting a cumulative total return of 83 per cent compared with 37 per cent from the Small Cap/Aim blend and 35 per cent from the FTSE All-Share (see graph). Over the period the FTSE Small Cap on its own managed a mammoth 72 per cent total return. If I factor in a 1.5 per cent annual levy for dealing costs and those high small-cap spreads, the cumulative total return over the three years is 74 per cent.

 

PIOTROSKI OVER THE YEARS

Total return6 Jan 2012 - 9 Jan 20139 Jan 2013 - 7 Jan 20147 Jan 2014 - 13 Jan 2015
Piotroski29%53%-7.1%
FTSE Small Cap/Aim17%25%-8.7%
FTSE All-Share14%18%1.0%
FTSE Small Cap  31%30%0.8%
FTSE Aim All Share2.6%21%-18%

Source: Thomson Datastream

 

Piotroski versus indices

Source: Thomson Datastream

 

Improving my Piotroski screen

Having recognised the small-cap bias of the Piotroski screen, the question is whether the screen can be broadened out to include more large caps? I am attempting to do this by conducting separate Piotroski screens this year for the FTSE 350, FTSE All Small and FTSE Aim All Share. This way, large caps only need to be among the cheapest in among all larger companies rather than competing with cheap small caps too. This was the technique I also applied for the 'Piotroski-value-hunt' screen which I introduced last August. That screen looks for stocks that have a high Piotroski 'F score' but are cheap on metrics other than the classic P/BV measure of value.

Leaving aside questions about what to compare the Piotroski screen's performance against, the screen itself remains high risk. This is clear when viewing last year's on a stock-by-stock basis, as can be seen in the table of 2014's share picks below. This reflects the fact that, even after applying Piotroski's filters, many companies that on the face of it look cheap have been priced down for good reason. And risks are abundant in this year's share picks as the screen is very keen on shares with exposure to two major areas of uncertainty - commodity prices (five out of 12 shares) and Russia (three shares out of the 12, two of which are also resources companies).

NameTIDMTotal return (7 Jan 2014 - 13 Jan 2013)
Spirit Pub CompanySPRT44%
Unitech Corporate ParksUCP27%
Highcroft InvestmentsHCFT22%
STMSTM10%
Peel HotelsPHO7.8%
LMS CapitalLMS7.1%
Rambler Metals & MiningRMM-25%
Enterprise InnsETI-26%
Real Good FoodRGD-29%
AmbrianAMBR-30%
NatureNGR-45%
Raven RussiaRUS-49%
Average--7.1%
FTSE All-Share-1.0%
FTSE Small Cap  -0.8%
FTSE Aim All Share--18.2%
FTSE Small Cap/Aim--8.7%

Source: Thomson Datastream

 

While the Piotroski screen tends not to able filter out all the duds, it is able to pick out many big winners which have a tendency to balance out the failures. Indeed, the beauty of the Piotroski screen, which was devised by accountancy professor Joseph Piotroski and published in a paper in 2000, is that it uses a number of fundamental factors to attempt to sort the wheat from the chaff. In the 20 years that were tested up to 1996, Mr Piotroski found his way of separating real value shares from "cheap-for-a-reason" shares worked, with a long-short approach based on his criteria. The method produced an average annual return of 23 per cent, almost double that achieved by the S&P 500. Mr Piotroski required stocks to pass eight or more of his nine fundamental tests as well as having a P/BV in the lowest quartile. The fundamental tests are:

■ 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.

 

It's worth noting that all the above tests focus on historical data. That means the screen cannot account for the impact of things such as sanctions against Russia or a large drop in commodity prices on futures reported earnings. This could prove a major weakness for the Piotroski screen if these themes continue to weigh on sentiment given that almost half the 2015 picks have exposure. But Piotroski's screening parameters are clear and the fact that they force one to turn a blind eye to current market noise can often prove a big advantage. Let's face it, while commodity prices and political events in Russia are incredibly hard to call at the moment, there could be a lot of value on offer from high-risk commodity plays if the current pessimism eases.

As usual with my Piotroski screen, I have excluded all companies with market caps of £10m or less. 13 shares made it through the screen. Five are from Aim and the FTSE 350 and the Small Cap have provided four shares each. The four stocks that passed all nine of the Piotroski tests are get short write-ups below and the remaining stocks appear in the table that follows which is ordered from lowest to highest P/BV.

 

THE 2015 PIOTROSKI PICKS