A casual glance at these numbers as you screen for various stocks can easily cause confusion. The Piotroski F-Score gives 1 point for each of 9 metrics deemed important. Therefore, a 9 is a perfect score and anything less than a 7 is considered riskier. As an example of the possibility for confusion, see the list of stocks below with their designated F-Score:
Rollins (ROL): 7
Legg Mason (LM): 7
Radio Shack (RSH): 6
General Dynamics (GD): 5
Monster Beverage (MNST): 5
Big Lots (BIG): 5
Hewlett Packard (HPQ): 4
One could easily conclude that RadioShack is less risky than General Dynamics or Big Lots, or that Legg Mason (LM) or Rollins (ROL) is the best choice. Which is it? We are missing one very important point. Piotroski based his findings on one very important “pre-screening” qualification. That is a high market to book value. The opposite of the P/B ratio, Piotroski made it very clear that a precondition for screening was finding stocks that have high market to book value. This means that for the majority of stocks, the F-Score doesn’t serve much purpose.
Since it is easier for value investors to use the easier terminology to find low price to book values and it is easier to screen for them, I will use this terminology for the remainder of the article. In our examples above, all of the stocks, with the exception of Legg Mason (LM), have a higher price to book value than would normally be used to apply the screen. Piotroski determined that stocks that were in the low end or 20% of the price to book ratio of the market were best suited for this application and that the stocks with a price to book ratio greater than the 20% of the market were not well-suited. The price to book for the market is approximately 1.5, depending on your source, so roughly speaking, we would only consider stocks with a price to book ratio of 1.5 or less to apply Piotroski’s screen. Piotroski was looking for stocks that were beat up, but improving. That was his intent, and he discovered that finding those stocks could add an additional 7.5% improvement on returns. In his paper, he says: Although this paper does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms, it convincingly demonstrates that investors can use past historical information to eliminate firms with poor future prospects from a generic high BM portfolio. I show that the mean return earned by a high book-to-market investor can be increased by at least 7½ percent annually through the selection of financially strong high BM firms and the entire distribution of realized returns is shifted to the right.
Once again, Piotroski is using this screen only for low-P/B picks and separating the weak from the stronger or improving. It was not and is not intended for the majority of stocks. So let’s apply the screen and understand that prior to using it, one must find the low-P/B stocks first. Reviewing the Piotroski screening method, one point is given for each item and then totaled. Any stock with a number greater than 7 appeared to pass muster with Piotroski. Score 1 point for each of the following if:
1. Net Income is positive.
2. Operating Cash Flow is positive.
3. Return on Assets is greater than the prior year.
4. Operating Cash Flow must exceed Net Income.
5. Long-Term Debt/Assets ratio should be improving or the ratio is down.
6. Current Ratio improves from prior year.
7. Shares Outstanding have either decreased or remained the same.
8. Gross Margin has improved from prior year.
9. Asset Turnover is greater than prior year.
Remember that if the stock has a P/B greater than 1.5, it will be or should be eliminated. It doesn’t mean that we cannot use this information, but we should not be applying the F-Score as Piotroski intended. He was only looking for the cigar butt stocks that were improving, so to speak. Here are some stocks that meet his screening technique, known as the F-Score, that you can use for future research:
Current Price: $26.85
Notes: Recent insider buying and new recent buys by gurus Ray Dalio and David Einhorn.
Current Price: $22.55
Current Price: $22.43
Notes: Held by Joel Greenblatt and Charles Brandes
Current Price: $5.90
Notes: Held by nine gurus and considerable inside buying taking place
To conclude, remember the intent of the F-Score and don’t be bothered by its score for the majority of stocks. With that said, it can still be a great tool for those stocks that should not have their F-Score applied due to a higher P/B ratio. At a glance, it’s always great to see that the current ratio is improving or that gross margins are improving, but remember that this screening technique is meant for beat-up stocks that are showing signs of life.
Disclosure: No positions in any stocks mentioned.