London-listed stocks have enjoyed mixed fortunes in 2011, with a bright start quickly unravelling over the summer as macro economic concerns damaged investor sentiment. With the FTSE 100 and FTSE AIM 100 both down substantially on where they were one year ago, investors seeking to find bargains face challenging questions. On the one hand, market declines are presenting apparently attractive opportunities to buy equities cheaply but on the other, in the light of the precarious economy, the task of selecting which stocks offer the best chance of gains over the medium term is all the more demanding.
For followers of Joseph Piotroski, a celebrated accounting professor at the Stanford Graduate School of Business, the conditions merit the use of a formula that has frequently helped investors identify opportunities in tough markets. Piotroski is behind the F-Score, a simple indicator to highlight stocks showing the most likely prospects for outperformance amongst a basket of apparently undervalued companies. He first outlined his theory in an April 2000 paper entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” Since then, it has won an army of followers and in the bear market of 2008, was hailed by the American Association of Individual Investors as the only one of 56 screening tools to produce a positive return for investors.
Piotroski’s starting point is a list of companies that are, on paper, the most undervalued on the market. You arrive at a list of “value” stocks by dividing what the market is pricing them at by what each company’s total assets are stated to be worth and concentrating on the cheapest 20% of companies. This price-to-book value list generally produces a collection of companies that, on a pure valuation basis, can appear to be mispriced. A quick scan of such a list will show that there may be very good reasons why investors won’t touch companies in this basket – they can often be financially stricken or even basket-cases.
The overarching question is however why each company is being undervalued and whether it is justified. It could be any number of factors including serial underperformance, financial calamity, investor ignorance, poor communications, an unsexy sector or an unappealing business model. Whatever it may be, these companies are out of favour and Piotroski’s theory seeks to pick the ones that offer the best chance of recovery…
Piotroski's F-score formula is simple and doesn’t require any difficult maths, but produces an elegant analysis that can also be customised to fit the risk tolerance of individual investors.
