I had to read it again for grasp its full significance.
I had stumbled onto, what is most likely, the best tool you can use to substantially improve your investment returns.
In a research paper, written in 2000, an unknown accounting professor from the University of Chicago, developed and successfully tested a system where, with the use of a few simple accounting based ratios, so easy to calculate you can do it on the back of an envelope, you can achieve substantial index beating investment performance.
Beating the index may at first not sound that impressive but, if you consider that more than 80% of investment funds worldwide do not even manage that, using this system will easily put your returns in the top 10% of investors worldwide.
Remarkable is that this information still seems to be relatively unheard of amongst investors.
First something on the man behind the study.
The developer of the system is Joseph D. Piotroski is relatively 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.
In 2000, he wrote a research paper called "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" (pdf).
He wanted to see if he can develop a system (using a simple nine-point scoring system) that can increase the returns of a strategy of investing in low price to book (referred to in the paper as high book to market) value companies.
What he found was something that exceeded his 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 out-performance over the market of 13.4%.
This is truly outstanding if you think of 80% of investment funds, mentioned above, not even beating 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%, substantially outperforming the average S&P 500 index return of 15.83% over the same period.
This average out-performance of the index of just over 7% may not seem like much but over the 20 year period an investment of 100 in this long short investment 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!
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.
How is the Piotroski or F-Score calculated?
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