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Piotroski value screen update

Created:

6 May 2008

Written by:

David Stevenson

There's plenty of evidence to suggest that this highly detailed way of finding well run, cheap value stocks can produce amazing long term results. In the US, various versions of the screen have produced portfolio returns of more than 1000% while over here in the UK our own backtest of the screen has produced some impressive returns (see the table on returns from our back-testing study). We still think this screen – based on the ideas of Chicago accounting professor Joseph Piotroski – will pay off in the long term because of its focus on asset rich, well run companies.

Piotroski – undervalued small cap stocks

Step One: screens

• PBV top quartile of the market

• Market cap of £10m or more

• ROCE is at least positive

• ROCE trend in last few years positive

• Positive cashflow in last year. PCF is positive

• Margin trend positive in last few years

• Cashflow per share trend is at least positive

• Cashflow divided by EPS is at least 1. Net gearing below 100%

Step Two: screens

• Positive evidence of insider buying.

• Net borrowings trending downwards if there are any debts

• Asset turnover is rising , preferably

• The current ratio is rising, preferably

• Cashflow per share has been consistently rising

• EXCLUDE a share if the cashflow at the operating level has in the last period turned negative or crashed

Step Three: screens

• ROCE equal or more than sector average

• Net margin equal or more than sector average

WATCH out for...

• Net borrowing trending downwards

• Current ratio rising

• Cashflow per share consistently rising

• EXCLUDE sudden cash negative turnaround

• ROCE and Margin average or above for sector

April was a good, solid and successful month for this portfolio, with the overall return increasing from 4.7% to 9.1%. That's partly because our two most recent additions have quietly stormed ahead – Tinopolis is up 16% and Microgen is up 10% in just one month. Crucially bargain basement miner Mwana Africa has stormed ahead as the blighted citizens of Zimbabwe finally begin to contemplate a world after Mugabe. If we were to exclude shares sold out because of triggered stop losses i.e the current running portfolio, you'd be currently ahead 43% which is we think a superb performance.

• Buy Air Music and Media at 29.5p. Although this independent distributor of DVDs and music to the big retail chains is on the receiving end of a bid we think these shares could go a lot higher. Air Music and Media has had a horrid few years as its struggled to up its margin in a cutthroat business but it now looks like it's turning a corner. A recent trading statement from the group noted that full year results for 2008 will be at a similar level to 2007, adding that third quarter turnover rose by 56% to £35.2m compared with the same time last year. We think the underlying profits of this business should be around £3m after excluding for any amortization, and any potential buyer we believe would need to pay at least 5 if not 7 times those cash earnings to buy the group. In our mind that implies a takeout price of between £15m and £20m, a big increase on the current market cap of £11m.

• Buy Gladstone at 23.75p. Here's yet another well run software company that we believe is hugely undervalued by the market. Recent results showed that its relentless focus on building it education business, as well as its margins and improving the cash position of the business is paying off. In its interims it reported that its current order-book and quarterly sales pipelines is "healthy" with six months profits up from £672,098 pounds to £1.08m as revenues increased to £4.36 million pounds from £4.24 million. Add in freehold property assets valued at £2.0m, cash of £5.0m and 3.3m of treasury shares, and you can begin to see why we rate this software minnow.

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