Hunting value, finding lots

When accountancy professor Joseph Piotroski came up with his system to identify companies with improving prospects, he married it with a measure of value that was highly regarded among academics at the time: the price-to-book (P/BV) ratio.

The P/BV ratio is great in theory. The book value of a company should tell investors two important things. One is an indication of what value may be salvageable for shareholders in the doomsday scenario that a company goes out of business. The other more important thing the ratio should indicate is the size of the asset base from which a company seeks to generate profits. Often value stocks have seen profitability sag, so having an idea about the raw potential for profit in sunnier times can be extremely helpful.

However, there is one big problem with book value today. For many companies it is entirely meaningless. The reason for this is that intangible assets have grown in importance for companies over several years. That’s especially true for the world's fastest-growing and most innovative companies. 

Intangibles include things such as patents, brands and software. Current accounting standards mean very little of the spending a company makes on such items is ever recorded as an asset. Instead it is treated as a day-to-day cost. That means very few intangibles are reflected in book value. So for intangible-intensive companies, P/BV tells investors very little, if anything at all. 

Indeed, classic long-short value strategies based on P/BV (buying stocks with the lowest P/BVs and shorting stocks with the highest) have become extremely ineffective, although some studies suggest such long-short strategies are actually more effective than they used to be in those remaining pockets of the market where book value still means something. These are pockets dominated by companies that predominantly invest in tangible assets such as property and machinery. 

In Piotroski’s landmark paper from 2000, titled 'Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers', he looked for cheap stocks based on P/BV that also had a high F-Score (more of what that is to follow). My F-Score Value Hunt screen attempts to take the bit of Piotroski’s methodology that may well remain useful to investors (his F-Score) while ignoring the bit that looks outdated (his focus on low P/BV stocks). 

Specifically, the screen looks for stocks that are cheap based on any of a range of other metrics and also have a high F-Score. This does not entirely get around the problems associated with intangibles discussed above. Some of the alternative valuation metrics have also become less reliable due to the rise of intangibles. This is the case for the price/earnings (PE) ratio and the price earnings/growth (PEG) ratio.

The F-Score itself is a lovely interplay between nine fundamental factors. The idea is that together these factors demonstrate that a company is improving its operational performance without having to draw on outside financing. The criteria is as follows:

■ Positive profit after tax, excluding exceptional items.

■ Positive cash from operations.

■ Profits after tax excluding exceptional items up on the previous 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 rerating.

■ Cash from operations 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) 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) 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 past year, which again suggests that the company has not had to look for external sources of finance.

■ Gross margins have risen in the past year.

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

Piotroski considered any company fulfilling eight or more of the criteria as having a high F-Score. This was the definition he used for his 20-year back-test to 1996 of a long-short strategy based on F-Score combined with P/BV. He found that over the period the strategy would have delivered an average annual return of 23 per cent. That was almost double the return achieved by the S&P 500.

Ignoring P/BV and instead combining a high F-Score with stocks that look cheap on one or more of a range of other factors has been pretty effective since I started to do this in August 2014. 

With beaten-up value stocks rallying hard since vaccine breakthroughs were announced last November, it will probably come as little surprise that last year was a strong one for the screen. The 32 stocks selected last year managed an average total return of 42 per cent compared with 36 per cent from an equal split of the FTSE All-Share, FTSE Small Cap and FTSE Aim All-Share.

However, the screen has put in decent numbers even while conventional value strategies have been struggling. Indeed, the cumulative total return from the screen stands at 147 per cent over the seven years I have followed it. That cumulative return is based on annual reshuffles at the time of the screen’s publication and gives equal weighting to each stock selected regardless of which index they come from. The combined return from the indices over that period is 78 per cent.

Interestingly, while the outperformance looks relatively smooth when combining the picks from all three indices screened, it is a bit of a different story if we hone in on the picks from each index. The smaller companies selection looks particularly erratic against the Small Cap index. Meanwhile, the All Share screen had a spectacularly gruesome drawdown in the Covid crash (the max drawdown of the full screen was still a fairly gnarly 43 per cent versus 38 per cent from the market). Perhaps this is a case for diversification.

In terms of the valuation ratios used by this screen, stocks must have a high F-Score, be amongst the cheapest quarter of those screened (the FTSE All-Share, All Small and Aim All-Share are all screened independently of one another) on one or more of the following: Dividend yield (DY); Price-earnings ratio based on rolling 12-month forecasts (Fwd PE +12mth); Enterprise value to sales (EV/S); and Genuine Value (GV) ratio, which is like a price/earnings growth ratio (PEG) but factoring in dividends and debt to the valuation.

This year, the F-Score Value Hunt has been prolific in its output. This probably shouldn’t be too much of a surprise given most companies tend to make good progress during an economic recovery, such as the one we’re currently experiencing. This may mean this year’s screen is more hit and miss than normal. To be fair, it’s pretty hit and miss anyway. However, on the plus side, for readers that are hungry for ideas, this year’s screen has lots of them. They are listed in the accompanying table along with details of the index they have been screened from, the measure(s) of cheapness they qualify on and a selection of fundamental data. 

Source: FactSet