Piotroski F-Score in the Real World

Two years ago I started a portfolio monitoring the performance of a portfolio constructed by using the Piotroski F-Score.

The reason for this test is to gather some real-life data on the F-Score’s usefulness for investors in finding investment opportunities. Indeed, the F-Score is touted as one of the best ways for investors to uncover undervalued, financially stable companies to buy. But does it work?

Finding value

The F-Score hunts out companies that are profitable, have improving margins, don't employ any accounting tricks and have strengthening balance sheets. One point is awarded for each criterion the company passes and the stocks that score the highest -- eight or nine -- are regarded as being the strongest candidates for recovery.

Piotroski recommended scoring the bottom 20% of the market by price-to-book value and then working from there. Using the following system, Piotroski's April 2000 paper, "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers," demonstrated that the Piotroski score method would have seen a 23% annual return between 1976 and 1996 if the expected winners were bought and expected losers shorted. According to the American Association of Individual Investors, the F-score screening criteria with a low P/B value would have returned 3.4% year to date. Over the past five years, this return would have been 33.9%, and the 10-year return 26.7%

The F-Score screening criteria are as follows:

Profitability signals

1. Net Income - Score 1 if there is positive net income in the current year.

2. Operating Cash Flow - Score 1 if there is positive cash flow from operations in the current year.

3. Return on Assets - Score 1 if the ROA is higher in the current period compared to the previous year.

4. Quality of Earnings - Score 1 if the cash flow from operations exceeds net income before extraordinary items.

Leverage, liquidity and source of funds

5. Decrease in Leverage - Score 1 if there is a lower ratio of long-term debt in the current period compared to value in the previous year.

6. Increase in Liquidity - Score 1 if there is a higher current ratio this year compared to the previous year.

7. Absence of Dilution - Score 1 if the company did not issue new shares (equity) in the preceding year.

Operating efficiency

8. Gross Margin - Score 1 if there is a higher gross margin compared to the previous year.

9. Asset Turnover - Score 1 if there is a higher asset turnover ratio year on year (as a measure of productivity).

As usual, however, this strategy cannot be employed alone; it needs to be combined with another screening tool to produce a suitable set of results. That being said, it should be pointed out that the F-Score was designed as a screening tool to use without the need for further analysis (such as competitor analysis, moat analysis or management analysis). With this in mind, the stocks selected have been chosen on nothing but the numbers alone.

To pull out the best opportunities, for the first year of the test companies were selected which met all of the above F-Score criteria but were also trading at a deep discount to book value per share.

Unfortunately, the first year of the test was unsuccessful. The value of the portfolio declined by 49.3% over the period thanks to a heavy weighting in oil and gas.

To try and get a better understanding of the ratio, its benefits and drawbacks, this year the F-Score was retested with some differences. As well as the standard test (selecting 20 the highest rated F-Score stocks trading at the widest discount to book) the 10 worst-rated F-Score stocks with the highest P/B values at the beginning of the year were shorted.

This time around, the results have been more favorable. The $20,000 test portfolio, which includes $1,000 per line of stock, is up $1,091.57 on the long side and $4,651.10 on the short side, for a total gain of $6,159.21, a return of 12.43% year to date, outperforming the S&P 500 by 1.93%. All figures are taken based on values before the market opened on Dec. 19. For the sake of simplicity, this excluded borrowing costs, dividend income and commissions. The raw data, including stock positions, is shown in the tables below.

Short portfolio

Long portfolio

Net results

”‹Disclosure: The author does not own any shares mentioned in this article.