The model that makes up about 80% of my stock picking process has undergone several minor adjustments, one following quickly after the other. Since I have referred to it quite a bit recently I thought it might be useful to thrash out the details as well as its history.
The model detailed here replaced a previous effort which I used through 2008-2010. The old model focused almost exclusively on the balance sheet rather than on earnings, but eventually I had to admit that earnings might be important so I started this new one from scratch, basing it on the strongest research I could find.
Version 0.1 – Fair value and the Piotroski F-score
First I calculate an approximate fair value for the company and hence its shares. I do this by taking the average of ROE10, ROE5 and ROE3 (which in turn are the 10, 5 and 3 year ROE averages) and using that as an estimate of the average future ROE under normal conditions. By blending those historic averages I weight recent results more heavily than results many years ago.
There are various issues with this approach that need to be manually looked at when selecting a company. For example, companies with extreme ROE figures in some years due to their book value being unusually small at some point. This might skew otherwise weak ROE results upwards and makes them look attractive.
I then assume that fair value is ten times my normal return estimate, which produces a target price from which I can calculate the upside from the current share price. This upside is the first factor in the model as it measures the capital gains you might reasonably expect in the long term.
Sorting companies by upside alone gives a top scoring decile (50 companies out of a universe of 500 with positive 5 year ROE) with these attributes: Normal ROE 15.8%; price/book ratio 0.64; Piotroski F-score 5.6; net gearing 45%; upside 234%.
I use the Piotroski F-score in an attempt to measure where the company is in the business cycle and therefore how far it may be from recovering and being re-priced back to normal levels. It's better to have a company with 50% upside that may return that amount in 6 months rather than one that may take several years.…
