The practice of fundamental analysis has no shortage of metrics, procedures, ratios and filtering criteria. Within this forest of tools, is there a place for the Piotroski F-Score?
The GuruFocus system gives it a relatively prominent place on the Financial Strength section of the summary page for most stocks. Here it is for one company (surrounded by a red ellipse):
We will examine the F-Score’s formula, history and at its application in screening and selecting value stocks.
The formula
Piotroski’s F-Score is based on the answers to nine questions taken from the financial statements of a company. Those nine questions can be divided into three categories: profitability, funding and efficiency. GuruFocus described the criteria on the F-Score pages:
Profitability
- Question 1. Return on Assets (ROA): Net income before extraordinary items for the year divided by total assets at the beginning of the year.
- Question 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.
- Question 3. Change in Return on Assets: Compare this year’s return on assets to last year’s return on assets.
- Question 4. Quality of Earnings (Accrual): Compare Cash flow return on assets to return on assets
Funding
- Question 5. Change in Gearing or Leverage: Compare this year’s gearing (long-term debt divided by average total assets) to last year’s gearing.
- Question 6. Change in Working Capital (Liquidity): Compare this year’s current ratio (current assets divided by current liabilities) to last year’s current ratio.
- Question 7. Change in Shares in Issue: Compare the number of shares in issue this year, to the number in issue last year.
Efficiency
- Question 8. Change in Gross Margin: Compare this year’s gross margin (gross profit divided by sales) to last year’s.
- Question 9. Change in asset turnover: Compare this year’s asset turnover (total sales for the year divided by total assets at the beginning of the year) to last year’s asset turnover ratio.
For each passing answer, the company is awarded one point (and no points on failed questions). The result will be a score between 0 and 9. The higher the score, the better. Generally, analysts put the scores in one of three categories:
- Good scores: 7 to 9
- Middling scores: 4 to 6
- Poor scores: 0 to 3
Value investors looking for winners would start at the top with the 9s and work their way down. Alternatively, investors looking for shorting opportunities would start at the bottom with 0s and work their way up. Generally, most investors will work either the top category or the bottom category.
Business Insider summed it up this way:
“Piotroski's approach essentially looks for companies that are profit-making, have improving margins, don't employ any accounting tricks and have strengthening balance sheets.”
Where it began
Source: Stanford University Graduate School of Business
In the year 2000, Joseph Piotroski was an associate professor of accounting at the University of Chicago’s Graduate School of Business and he published an article entitled, "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" (Journal of Accounting Research (Vol. 38, Supplement: Studies on Accounting Information and the Economics of the Firm)). He is now a full professor of accounting at the Stanford Graduate School of Business.
In the first sentence of the article, he lets the reader know where he is going.
“This paper examines whether a simple accounting-based fundamental analysis strategy, when applied to a broad portfolio of high book-to-market firms, can shift the distribution of returns earned by an investor.”
Note the key words: high book-to-market (value stocks), accounting-based, fundamental analysis, strategy, portfolio, distribution of returns (i.e., better returns).
In the second and third sentences, Piotroski consolidates his hold on the reader's attention by revealing this strategy outperforms his benchmarks.
“I show that the mean return earned by a high book-to-market investor can be increased by at least 7½% annually through the selection of financially strong high BM firms while the entire distribution of realized returns is shifted to the right. In addition, an investment strategy that buys expected winners and shorts expected losers generates a 23% annual return between 1976 and 1996, and the strategy appears to be robust across time and to controls for alternative investment strategies.”
An article in Stockopedia/Business Insider notes:
“Piotroski recognized that, although it has long been shown that value stocks (or high book-to-market firms as he calls them) have strong returns as a group, there is nevertheless very wide variability in terms of the returns of these stocks.”
And:
“What he [Piotroski] wondered was whether it was possible to weed out the poor performers and identify the winners in advance. He therefore sought to develop a simple accounting-based stock selection strategy for evaluating a stock’s financial strength.”
To put it another way, Piotroski is trying to figure out which discounted stocks are truly value stocks and which stocks will never recover.
All of which leads the reader to ask, “Given the outstanding returns Piotroski observed and the nearly universal desire among value investors to pick the right stocks, why isn’t the F-Score more widely used?”
Caveats to the Piotroski F-Score
Piotroski himself suggests limits to the universe of relevancy in his 2000 article:
“. . . the benefits to financial statement analysis are concentrated in small and medium-sized firms, companies with low share turnover, and firms with no analyst following. . . .”
All in all, this suggests a relatively small universe of stocks and an area of the market that gets less attention from value investors. It also suggests investors will find this tool helpful for stocks they do not have much information on.
Jim Fink, writing in a 2012 Investing Daily article, puts it this way:
“Professor Piotroski’s conclusions are partly based on illiquid microcap stocks with a median market cap of less than $15 million – such stocks are typically so thinly-traded as to be uninvestable.”
Piotroski also said:
“. . . this paper does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms. . . .”
Does the formula work?
Perhaps the biggest hurdle to the F-Score’s widespread acceptance is a lack of information about how it would perform in a real-world environment.
As observed, backtesting produced outstanding results. But, backtesting is theoretical investing and trading. Many of us have learned about the difference between theory and practice when we put our funds on the line; I can certainly testify to unexpected losses because of the gap between what should have happened and what actually did happen.
The American Association of Individual Investors says:
“While it is easy to be taken in by huge performance numbers, it is important to always look beyond the surface to discover the drivers behind the numbers. AAII’s Piotroski screen offers good performance, but also highlights very few stocks and is a high-risk strategy. As a result, this strategy does not translate to the real world of investing.”
And an article in Value Research (2015(?)) notes:
“Since the Piotroski F-score is based on recent performance and compares the current-year numbers to those of the previous year and that too on relative basis, it points more towards recent performers. If a company has a low score, that does not necessarily mean that its financial position is weak. But yes, they have not performed in the current year.”
Applications of the F-Score
No one, to my knowledge, has created a mutual fund or hedge fund based solely on the Piotroski F-Score.
However, user longshort at Marketocracy did create a virtual F-Score fund, which he or she described this way:
“This new "Quant" fund is based on Piotroski fundamental screening. Stocks must be at least an 8 on the 9 point Piotroski scale. They must also be either a ConvictionBuy or Buy on the LongShort AlphaInvestor scale, or have a 25% Margin of Safety by Graham Number. New Fund Nov 20, 2013.”
This table shows the composition of the fund (with probably more of a large cap presence than we would expect):
The returns (as we approach the fund’s third anniversary) on this virtual fund are not encouraging:
A unique approach to applying the F-Score comes from Steve Alexander of MagicDiligence.com, a website that analyzes stocks appearing in Joel Greenblatt (Trades, Portfolio)'s Magic Formula Investing screens. He says:
“. . . it's interesting to calculate the Piotroski scores for stocks on the Magic Formula screen. The highest scores should clearly indicate a cheap stock price put on a quality company with relatively strong business momentum -- a pretty solid recipe for success.”
“The average gain here is +10.3%, far outperforming the S&P 500's +6.2% performance over the same one-year period. We've seen good results using the Piotroski method as an additional filter on top of the Magic Formula® screens in the handful of times it has been tested.”
It appears Alexander’s returns are virtual or theoretical. Nevertheless, the exercise provides new and useful insights about value stocks, or should we say, potential value stocks.
Screening for high-scoring stocks
One can screen for stocks with high (or low) F-Scores by using the All-In-One screener at GuruFocus. As seen here, there are two areas where you can screen: using the preset at the top of the page or the manual selectors just below it:
Using the manual selectors, one can fine tune the screen to bring up only stocks with certain ratings (such as 7 to 9 for the highest-rated stocks).
Conclusion
On its own, the Piotroski F-Score does not deliver a lot; it has not been extensively tested in real trading or investing. Of course, Piotroski himself told us that the F-Score has its limitations and should be used in conjunction with other tools. One needs to ask, as noted in the AAII comment, about the drivers behind the numbers.
Nevertheless, it will be a useful tool for value investors who want to create a shortlist of stocks with strong financials. Granted, this is on a year over year basis, but a company that hits at least 7 on the scale probably has a decent history to go with the most recent year’s performance. Distinguishing between temporary bargains and long-term losers is at the heart of value investing, and Piotroski provides an accounting view that many will find helpful.
It will also, as Piotroski notes, be most helpful for small and mid-cap stocks, which we often know less about than large-caps. A list of 8s and 9s is bound to be a good starting point.
Finally, I am somewhat fascinated by the combination of Piotroski’s F-Score and Greenblatt’s Magic Formula. Someday, when I have the time, I would like to see for myself how well the metrics complement each other and how picks made with this combined list fare over several years.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
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