When Warren Buffett said that “time is the friend of the wonderful company, the enemy of the mediocre”, he was stressing his view that company quality is essential in investing. For him, ‘high quality’ is a pointer to firms with strong competitive advantages that can compound returns over long periods. While many will agree with that idea, it’s not always easy to know what really defines quality - and where it can be found in different situations across the market.
One way of tackling that challenge - and to get equipped with a way of assessing quality in any kind of stock - is to take a closer look at the Piotroski F-Score.
A quality checklist for all occasions
The F-Score was introduced in 2000 by an accounting professor called Joseph Piotroski. He’d constructed a checklist of nine accountancy-based questions that a company could either pass or fail. The higher the score, the better. But a key feature of Piotroski’s F-Score is that it looked back to previous financial results for signs of financial improvement or deterioration. So this was very much a way of looking at the fundamental health trend of a company.
Piotroski originally formulated the F-Score as a way of assessing value stocks. By studying financial health trends, he wanted to find out which of the cheapest stocks in the market was best placed to recover. His study showed that this worked very well. Cheap, high F-Score stocks did tend to outperform. But there was more…
In the years afterwards, the F-Score was picked up and put to the test by the research teams of investment banks like Societe Generale and Credit Suisse It was applied to real world investing situations - like this one by Credit Suisse - and was still shown to work well. As a result, the F-Score has been accepted by some of the best regarded investment teams as a useful proxy for quality in almost any situation.
Exploring the F-Score in detail
Digging into the detail, the nine F-Score checks are spread between three main areas of financial analysis. First is profitability, where it examines operating profits and cashflow to make sure the business can sustain itself and even pay dividends. These checks look for an improving trend in profitability, which in underpriced and potentially misunderstood stocks can be a sign that a turnaround is underway.
Three…
