Ten Piotroski picks

Over the past 12 months the 14 shares picked by the Piotroski screen last year delivered a total return of 4.7 per cent. That compares unfavourably with an average of 18.2 per cent from the three indices stocks are picked from – FTSE 350, FTSE All Small and the Alternative Investment Market (Aim). While the Piotroski screen delivered superb performance in the first few years I ran it, it’s hit some major turbulence more recently. That means the cumulative total return it has produced since I started to run it six years ago stands at 96 per cent compared with the 99 per cent average from the three indices. What’s more, if I factor in a 2 per cent charge to account for dealing costs, the total return drops to 73.8 per cent.

2017 performance

*Taken over

While these numbers may not look too impressive on the face of it, there’s good reason to set stall by the screening methodology. Indeed, in the 20 years that were tested by Mr Piotroski up to 1996, he found a long-short approach based on his criteria achieved an average annual return of 23 per cent, almost double that achieved by the S&P 500.

Mr Piotroski devised a great way to test for companies with improving prospects based on nine fundamental factors, which he outlined in his 2000 paper 'Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers'. Companies displaying all or most of the factors tend to boast improving productivity, profits and financial strength. Mr Piotroski found that what he called his F-score was a particularly useful indicator of future performance for cheap stocks, measured by price-to-book-value (P/BV). Indeed, this stands to reason as usually it is an anticipated or actual fall in the returns from a company’s assets that cause them to be priced cheaply compared with book value. Therefore when returns improve, so too should the valuation.

The Piotroski screen looks for companies that have a high F-score (defined by him as a score of 8 or 9) and have shares ranked in the cheapest quarter of those screened based on P/BV. The nine F-score criteria are listed below:

■ 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 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 suggest greater productivity.

My Piotroski screen is conducted separately on the FTSE 350, FTSE All Small and FTSE Aim indices. The reason for conducting it separately on the indices rather than all stocks together is to stop the screen results being too heavily weighted towards smaller companies, which tend to command lower valuations on the whole. This year 10 'cheap' stocks scored an F-Score of eight or more. They are ordered from lowest to highest P/BV in the table below. I’ve also taken a closer look at the stock with the lowest P/BV, the stock with the highest historic dividend yield and the stock with the lowest forecast earnings multiple.

Ten Piotroski picks

Source: S&P CapitalIQ

Vodafone (Highest DY)

Things may be looking up for mobile telecoms behemoth Vodafone (VOD) in 2018, not that the share price does too much to reflect that yet. Arguably, the most significant reason for optimism is an update the group made late last year that results would be ahead of expectations – beating expectations represents a very rare treat for anyone that has held these shares over the past decade. The key reason for the good news was better-than-expected trading in Vodafone’s key European markets. There are hopes this could be the start of a trend as increased use of data boosts demand for higher-quality networks, such as Vodafone’s. As well as lifting organic guidance for cash profit, the group said free cash flow was likely to be over €5bn as opposed to its previous guidance of “around” €5bn. This should help underpin confidence in the handsome dividend.

As well as seeing improved sales in Europe, Vodafone is benefiting from efforts to trim costs. Savings have been made through its Fit for Growth efficiency programme. It is hoped that a drive to increase the digitisation of the business through the VOD app can help Vodafone make savings at call centres, high-street shops and on third-party commissions.

Meanwhile, some noteworthy fears about competition could abate as 2018 progresses. In India, which accounts for 6 per cent of group sales, an extremely aggressive push into the mobile market by rival Jio has delivered a broadside. However, the disposal of some Indian assets and a planned merger with another Indian mobile telecoms group later this year should put Vodafone’s business in a stronger position. What’s more, Jio has started to raise prices and smaller players have been going under, reducing the overall competitive strain.

Meanwhile, in Italy a competitive threat is looming but not yet present. Iliad, which has made major inroads into the French mobile market, plans to move into Italy, where Vodafone generates about 4 per cent of total sales. However, Iliad’s bark may prove worse than its bite. Broker Numis points out that it will be using a far lower quality carrier for its network in Italy than it has done in France and it also has no real foothold in the Italian telecoms market, unlike its Gallic experience. What’s more, other Italian incumbents have fragile balance sheets, which may mean they are quicker to give ground to the new kid on the block. If the Iliad threat proves less of an issue than expected, Vodafone’s shares may benefit.

Finally, the prospect that a long-mooted deal with Liberty Global could happen this year brings a bit of merger and acquisition spice to the story.

Sylvania Platinum (Lowest P/BV)

The return on an investment in Bermuda-registered South African platinum and rhodium mining company Sylvania (SLP) is likely to be heavily influenced by two major factors outside the company’s control. First is the price of the metals it mines. The good news on this front is that price increases and local currency weakness means the rand basket price of platinum group metals has increased by about a quarter over the past year. However, the outlook is far from clear. While weak platinum prices and rising costs, particularly wages, have made many platinum mines unprofitable (Sylvania is not in this camp) with potential knock-on effects for supply, increased recycling and falling demand from the troubled diesel car industry are noteworthy headwinds. Meanwhile the price of rhodium, a metal Sylvania has more exposure to than typical platinum miners, tends to be erratic.

The second factor outside Sylvania’s control is the political environment in South Africa and its effect on the level of the rand. It is worth noting that Sylvania is less exposed to union-driven wage increases than most platinum producers. Due to its focus on extracting platinum from chrome tailings, labour accounts for about two-fifths of costs rather than two-thirds for underground mines.

External factors aside, there are reasons for optimism about the development of the business. The company recently completed the acquisition of a new chrome tailings dump close to its existing operations and where it believes it can cut costs by about 30 per cent. The R89m (£5.3m) deal adds 8.5Koz to Sylvania’s 70Koz production base. In addition to these tailing operations, Sylvania owns a number of exploration assets.

Investment as well as acquisition is adding to the company’s potential. Sylvania is investing in a plan, called project Echo, to boost the efficiency and deliver 10 more years of sustainable production from its operations. This will require higher capital expenditure over the next two years, but the robust balance sheet and strong operating cash generation means the company is in a good position to fund the spending.

This investment is expected to curtail cash returns to shareholders until 2020, but the wait may prove well worth it. Broker Liberum expects net debt to be $16m by the end of the 2020 financial year, but also expects free cash flow to surge in those 12 months, providing the potential for a bumper dividend. What’s more, while the metal price and political uncertainties mean forecasts need to be taken with a pinch of salt, the current price represents a tantalising 18 per cent free-cash-flow yield based on 2020 forecasts. Meanwhile, Liberum puts a 20p net present value on the shares.

Babcock International (Lowest Fwd PE)

It may be of some reassurance to investors in Babcock (BAB) that it has been highlighted by a screen searching for companies showing signs of improving fundamentals. That’s not to suggest the F-Score isn’t fallible, but Babcock’s shares had a drubbing in 2017 as the fundamentals of many of its peers deteriorated sharply and investors became anxious that the company would follow a similar path.

Babcock is an outsourcer and as such is in the business of bidding for large, complex contracts that extend over many years. Big upfront costs and gallant estimations about commercial outcomes for many years to come are intrinsic to this business model. The experience of peers suggests that in the main this is a bidding process that is always likely to favour optimists. But the problem for companies that are overoptimistic is that at some point reality bites. Reality often means an unravelling of the assumptions that have historically underpinned balance sheets and income statements. Carillion is an unfortunate case in point.

However, Babcock stands out as the outsourcer that has yet to deliver truly terrible news. Arguably, the specialist and highly technical nature of its operations has protected it from cut-throat price-driven competition. This impression is supported by the fact that it recently said a new accounting rule regarding revenue recognition on long-term contracts – IFRS 15 – would not have any major impact.

That said, investors still appear nervous. Sentiment was not helped by some recent major negative movements in working capital, despite the fact the company had plausible enough reasons to highlight these as “one-offs” which probably would not have raised an eyebrow in a more favourable industry environment. Recent order book weakness has been another issue as it plays to concerns that Brexit is slowing government decision-making. Still, the group’s bid pipeline looks good and plans to bring down debt could also increase investors’ confidence in the year ahead.

If worries about Babcock do prove misplaced, the shares are certainly very cheap. But given the backdrop this is definitely a bit of a contrarian play.