Book-to-market and then some
By the time Piotroski embarked on the research that eventually culminated in his January 2002 paper, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, financial academics were already well aware of tendencies on the part of high book-to-market stocks (or as investors might say, stocks with low price-to-book value ratios) to perform relatively well. But such notions applied to the category as a whole. When looking stock to stock, it often turned out that the good numbers came from a small number of stocks and that many such issues were, in fact, duds. Piotroski wondered about finding a systematic way to separate the wheat from the chaff.
His paper documents the success he had doing just that using "a simple accounting-based fundamental analysis strategy." What's especially interesting about this particular paper is how short it is on advanced higher-mathematical notations and formulations and how long it is on basic investing common sense. Piotroski actually uses the word "heuristics" (which refers to concepts discovered through investigation, trial-and-error, etc.) and the phrase "simple screens." That's quite different from what you'll see in other major papers, where the concepts (capital asset pricing model, Gordon dividend discount model, Black-Sholes option pricing model, Markowitz efficient portfolio strategy, etc.) are very carefully and mathematically "derived" and presented as inevitable manifestations of the logic of the universe itself. Perhaps that's why Piotroski's strategy can work in the real world (see below) while this question can be very controversial when it comes to the other prominent research efforts.
The way it works is quite straightforward. It starts by defining a low price-to-book value universe, a value group. And as value investors know all too well, cheap stocks are often cheap for a reason, usually something to do with poor corporate health and/or prospects. The heart of Piotroski strategy is a ranking system designed to identify the healthiest among these companies. The goal is to wind up with bargain-priced shares that, based on company fundamentals, probably don't deserve to be as cheap as they are.
The Portfolio123 Joseph Piotroski model
This model reflects the general principles used by Portfolio123 for its All-Star screens (stand-on-their-own models inspired by key elements of the All-Stars' approaches), which can be seen here.
The Portfolio123 Joseph Piotroski model is built on the concepts identified in the 2002 paper although the details of implementation are our own. For example, Piotroski scores his variables on a one-or-zero basis depending on whether a condition is met, adds them up, and then ranks the scores. We use the pass-fail criteria to establish a basic screen (we differ from Piotroski in that our model will not allow any company to fail any of these screening tests). Then we build a ranking system based upon best-to-worst scores in these same factors, with extra emphasis on the price-to-book scores. Here are the details:
The screen uses the following rules:
Liquidity filter: Universe(foliofn), which means the stock must be tradable in the Folio Investing.com window system; for backtesting purposes, substitute a rule that bars OTC stocks. (Click here for more information)
Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek
Trailing 12 month "Business Income," defined as Sales minus Cost of Goods Sold minus Selling, General & Administrative expenses (unusuals that are often included in "operating Profits" are eliminated) but be in the black
Trailing 12 month Cash from Operations per share must be in the black
Trailing 12 month Cash from Operations per share must exceed trailing 12 month EPS
Trailing 12 month Gross Margin must exceed Gross Margin for the prior 12 months
Debt-to-assets in the latest quarter must be less than Debt-to-assets in the prior-year quarter
Current Ratio in the latest quarter must be less than Current Ratio in the prior-year quarter
Trailing 12 month Asset Turnover must exceed Asset Turnover for the prior 12 months
Trailing 12 month Return on assets must exceed Return on assets for the prior 12 months
Average shares outstanding in the trailing 12-month period must be less than average shares in the prior 12-month period
Among the companies that pass the above screen, we select the top 15 based on the Piotroski ranking system, which uses the following factors:
Price-to-Book, latest quarter - 50% of total
Fundamentals - 50% of total
Trailing 12 month Gross Margin minus Gross Margin for the prior 12 months (14.29% of category)
Trailing 12 month Cash from Operations per share minus trailing 12 month EPS (14.29% of category)
Debt-to-assets in the latest quarter minus Debt-to-assets in the prior-year quarter, lower is better (14.29% of category)
Current Ratio in the latest quarter minus Current Ratio in the prior-year quarter (14.29% of category)
Trailing 12 month Asset Turnover minus Asset Turnover for the prior 12 months (14.29% of category)
Trailing 12 month Return on assets minus Return on assets for the prior 12 months (14.29% of category)
Average shares outstanding in the trailing 12-month period minus average shares in the prior 12-month period, lower is better (14.29% of category)
Portfolio123 users who would like to examine the details or copy the models for their own use, may do so:
Click here for the Joseph Piotroski screen
Click here for the Joseph Piotroski ranking system
Backtest results
Figure 1 and Table 1 show the results of a five-year backtest that ran through 1/12/10 which assumes rebalancing every four weeks and selection of the top 15 stocks as per the screen sorted on the basis of the Joseph Piotroski ranking system.
Figure 1
There's a cliche: "Those who can, do. Those who can't, teach." Given the way Piotroski's strategy can work in the real world, this is one clich? that needs to be reevaluated.