In an unknown research paper, written in 2000, a University of Chicago accounting professor proved how a simple ranking system can help you make better investment decisions. Remarkable is that this information seems to be relatively seldom used by investors.
Before I tell you more about the ranking system, first something on the person behind the study.
Meet the professor
The developer of the system is Joseph D. Piotroski an unknown accounting professor who shuns publicity and rarely gives interviews.
He graduated from the University of Illinois with a B.S. in accounting in 1989, received an M.B.A. from Indiana University in 1994. Five years later, in 1999, after earning a Ph.D. in accounting from the University of Michigan, he became an associate professor of accounting at the University of Chicago.
The research paper
In 2000, he wrote a research paper called "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers".
He wanted to develop a ranking system (using a simple nine-point scoring system) to increase the returns of a low price to book investment strategy (referred to in the paper as high book to market).
What he found
What he found was something that exceeded his (and my) most optimistic expectations.
Buying only those companies that scored highest (8 or 9) on his nine-point scale, or F-Score as he called it, over the 20 year period from 1976 to 1996 led to an average yearly outperformance over the market of 13.4%.
This is truly outstanding if you remember that 80% of investment funds do not even beat the index.
Even more impressive were the results of a strategy of investing in the highest F-Score companies (8 or 9) and shorting companies with the lowest F-Score (0 or 1).
Over the same period from 1976 to 1996 (20 years) this strategy led to an average yearly return of 23.0%, substantially outperforming the average S&P 500 index return of 15.83% over the same period.
This average outperformance of the market of just over 7% per year may not seem like much but over the 20 year period an investment of 100 in this long short strategy would have grown to 6,282 compared to an amount of only 1,860 if you invested in the S&P 500 index.
The difference between these two rates of return over the 20 year period is over 44 times your initial investment!
Does it also work in Europe?
After getting really excited about the returns I asked myself if this would also work in Europe and in the current market environment.
But more on that later, lets first look at how the Piotroski F-Score is calculated.
How is the Piotroski F-Score calculated?
The Piotroski F-Score is calculated with the use of the following 9 ratios;
1. Return on assets (ROA)
Net income before extraordinary items for the year divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative
2. Cash flow return on assets (CFROA)
Net cash flow from operating activities (operating cash flow) divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative
3. Change in return on assets
Compare this year’s return on assets (1) to last year’s return on assets.
Score 1 if it’s higher, 0 if it’s lower
4. Quality of earnings (accrual)
Compare Cash flow return on assets (2) to return on assets (1)
Score 1 if CFROA>ROA, 0 if CFROA<ROA
5. Change in gearing or leverage
Compare this year’s gearing (long-term debt divided by average total assets) to last year’s gearing.
Score 1 if gearing is lower, 0 if it’s higher.
6. Change in working capital (liquidity)
Compare this year’s current ratio (current assets divided by current liabilities) to last year’s current ratio.
Score 1 if this year’s current ratio is higher, 0 if it’s lower
7. Change in shares in issue
Compare the number of shares in issue this year, to the number in issue last year.
Score 1 if there is the same number of shares in issue this year, or fewer. Score 0 if there are more shares in issue.
8. Change in gross margin
Compare this year’s gross margin (gross profit divided by sales) to last year’s.
Score 1 if this year’s gross margin is higher, 0 if it’s lower
9. Change in asset turnover
Compare this year’s asset turnover (total sales divided by total assets at the beginning of the year) to last year’s asset turnover ratio.
Score 1 if this year’s asset turnover ratio is higher, 0 if it’s lower
Piotroski or F-Score = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9
Good or high score = 8 or 9
Bad or low score = 0 or 1
How you can best use the Piotroski F-Score
As you can see from the way the Piotroski F-Score is calculated it is really a measurement of the financial quality of a company.
Or said in a different way it is a measurement of the fundamental momentum of a company.
It does not tell you anything about the valuation - expensive or cheap - of the company.
The F-Score is thus best used along with another valuation measure such as price to book ratio (as a first screening measure) where after you use the Piotroski F-Score to select only quality companies.
Does it work in Europe?
Back to the question if the Piotroski F-Score works in Europe and in the current market environment?
The answer is a clear yes!
And was convincingly answered in the research paper I wrote with my friend Philip Vanstraceele called Quantitative Value Investing in Europe: What works for achieving alpha
The following example shows how the Piotroski F-Score increased the returns of a simple Price to Book strategy.
If you only used Price to Book
The table below shows the returns you could have earned if you only used a low Price to Book value strategy to invest in Europe over the 12 year period 13 June 1999 to 13 June 2011.
Q1 (Quintile 1) represents the cheapest 20% of companies in terms of Price to Book ratio and Q5 (quintile 5) the most expensive.
The strategy worked well as the lowest Price to Book companies (Q1) substantially outperformed the market, which over the same 12 year period returned 30.54%.
Price to Book with Piotroski F-Score
If you combined the low Price to Book strategy with the 20% of companies with the best (highest) Piotroski F-Score the following tables shows what your return would have been over the same 12 year period.
Click image to enlarge
To get the above results we first selected the 20% of companies with the lowest Price to Book ratio.
We then sorted these companies into five quintiles, quintile one (Q1) was the most undervalued and quintile 5 Q5 the most overvalued in terms of each of the ratios of indicators in the column called Factor 2.
You can see that if you selected only the best Piotroski F-Score companies the return of your low Price to Book ratio investment strategy would have increased from 400.4% to 685.2% (Row: F Score Column: Q1), an improvement of 284.9% over the 12 year period.
The Piotroski F-Score improved every strategy
In the research paper selecting the best Piotroski F-Score companies not only improved the returns of a low Price to Book strategy it also improved the returns of other strategies.
- Returns from a high Earnings Yield strategy was increased from 236.3% to 447.1% (+210.8%)
- Returns from a high Free Cash Flow Yield strategy was increased from 317.4% to 568.7% (+251.3%)
- Returns from using Joel Greenblatt’s Magic Formula was increased from 182.8% to 349.0% (+166.2%)
How you can use the Piotroski F-Score in the screener?
This is how you can screen for low price to book ratio (high book to market ratio which is the inverse of price to book) screen with a high (good) Piotroski F-Score.
You can of course use any other valuation ratio and even add two other criteria with the two further sliders the screener offers you.
Not wildly popular
What is really remarkable is that, in spite of the substantial benefits the F-Score can add, it has not been taken up more widely by investors and the asset management profession.
I strongly suggest that you give the Piotroski F-Score a try, as the above evidence show, it will substantially increase your investment returns, irrespective of what investment strategy you may be following.
P.S. Here is another interesting article on the Piotroski F-Score: Can the Piotroski F-Score also improve your investment strategy?
PPS To get the Piotroski F-Score working in your portfolio sign up here
Other interesting Piotroski F-Score articles
Here are other interesting article about the Piotroski F-Score: