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I screened for stocks with a perfect score of 9 for the F-Score and a P/B ratio of less than 1. Three stocks, MOD-PAC Corp. (MPAC), P&F Industries Inc. (PFIN) and Nortel Inversora S.A. (NTL) passed the test with flying colors. As a result, I found imperfections with the F-Score that I would like to share with readers.
Firstly, the F-Score focuses on improvement, rather than absolute levels. MPAC improved its gross profit margin from 17.14% in the previous year to 17.63% this year. The increase of 0.49% in gross margin and 17% gross margin by itself is nothing to shout about. Also, PFIN's debt/equity decreased from 49% last year to 34% this year. Despite a significant reduction in leverage, a debt/equity ratio of 34% is still considered high. By focusing only on improvement instead of absolute levels, firms with low profitability and high leverage can still get a perfect F-Score.
Secondly, the F-Score is not timely for contrarian value investing. If you wait for the robins, spring will be over. For many stocks especially the depressed cyclicals, the best time to enter into a position usually happens when the fundamentals of the companies are at their trough. The F-Score will pick up only these depressed stocks when there is an indication of improvement in financial metrics. By that time, the stock prices will have priced in the recovery, making valuations unattractive.
Lastly, the time frame for the F-Score is too narrow. The F-Score typically compares this year's financial metrics against those of last year and could create distortions in perception. For example, the F-Score requires a positive divergence between cash flow from operations and net income before extraordinary items. It will be a fairer assessment if the divergence between cash flow operations and net income is evaluated on a multi-year basis. Cash flow from operations could fall below net income in any single year as a result of the timing in recognition of net income.
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As long as it is a strategy that makes sense and has been proven to work over a long time... If the principles are implemented through a disciplined strategy, it will give you an edge over time. It has been proven to work over the long term when you hold a diversified portfolio (30+) of these highly ranked stocks chosen within the lowest p/b ratios pool of stock (lowest 20% p/b).
That's why it is important to be well diversified. Quantitative screening won't just magically find the three best bargain stocks for you right now. It's just helping you find above average opportunities, on average. I would not give it too much weight to the F-Score alone unless it is implemented into a long term, diversified strategy with strict, unemotional buy sell decisions (1 yr holding period).