Stock market moguls embody a wide spectrum of personalities and philosophies. There are those that are fixtures in the media or the basis for fictional characters in books and movies, even some that have passed on but left an indelible mark in the investment world psyche.
And then there are the roll-up-your-sleeves, no-frills, in-the-trenches experts that combine academics, theory and investment strategy. A good example would be Joseph Piotroski, the inspiration behind my Book/Market Investor stock screening model. Piotroski, a CPA, earned an MBA in Finance from Indiana University and a Ph.D in accounting from the University of Michigan. He is an accounting professor at Stanford University, holds numerous awards and honors and has penned countless articles, book chapters and working papers.
It should come as no surprise that this quant's contributions to the field of stock market analysis make him worthy of guru status. In 2002, while teaching at the University of Chicago, Piotroski published a highly regarded paper entitled "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers." In it, he laid out a value and accounting-based stock-selection method that produced a 23% average annual back-tested return from 1976 through 1996 -- more than double the S&P 500's gain during that time.
Piotroski's research focused on companies that had high book-market ratios, the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (market capitalization, equal to share price times number of shares outstanding). Using this as well as a series of accounting-based measures, he developed a methodology to identify stocks with winning potential.
In my book The Guru Investor (Wiley, 2009), Piotroski's approach is described in detail along with an explanation of the investment strategy I developed based on his philosophy. While certainly not the first to study high book-market (or low price-to-book) value stocks, Piotroski went a step further to examine the inner workings of the underlying businesses. In so doing, he realized that in many cases such companies sport high B/M ratios (which he defined as those in the top 20% of the market) because they are in financial distress rather than because they are being unfairly overlooked. So, in order to weed out the weaker companies and identify good opportunities, Piotroski used a series of balance sheet-related criteria (a natural tendency given his accounting background) which fell into three basic categories:
- Profitability-positive earnings and cash flow.
- Liquidity and Leverage-ability to meet debt obligations with operating cash flow.
- Operating efficiency-how a company makes use of its earnings to grow its business.
He also took stock size and risk levels into account. Specifically, he found that the smaller high book-market firms were more likely to produce high returns than their larger counterparts. He attributed this to the fact that small cap stocks more often fly under the radar of analysts and investors, thus offering a better chance of uncovering winners. Piotroski also found that the healthiest high book-market firms were actually the most likely to perform well.
Using my Piotroski-inspired stock screening model, I've identified the following four high-scoring stocks. All of these names have book-to-market ratios in the top 20% of all stocks, which is the initial criteria required in the model:
1. Atwood Oceanics, Inc. (ATW)
Atwood Oceanics is an offshore drilling company engaged in the drilling and completion of exploration and development wells for the global oil and gas industry. My Piotroski-based screen favors the company's return-on-assets of 8.97%, which represents an increase over the prior year (7.48%). Operating cash flow ($604.29 million) meets the requirement to exceed net income ($430.72 million), and long-term debt is a comfortable 35% of total debt-assets. The company's liquidity (current ratio) is 4.47, up from 2.97 in the prior year.
Trinity Industries is a diversified industrial company that owns a range of businesses providing products and services to the energy, transportation, chemical and construction sectors. The company's operating cash flow of $939.70 exceeds current year net income ($776.22 million) by a comfortable margin, and return-on-assets has increased from 7.50% in the prior year to 8.73%. Long-term debt-to-assets is .36, an improvement over the prior year (0.40).
KT Corporation is a telecommunications service provider. This company earns a perfect score under our Piotroski-inspired screening model based on its positive return-on-assets (1.40%) which represents an increase over the prior year. Operating cash flow of $3.77 billion offers a comfortable cushion over current year net income ($367.28 million), and gross margin has held steady at 101%. Current ratio has increased from the prior year to .99, and long term debt-assets ratio is modest at 0.24.
LG Display manufactures thin-film transistor liquid crystal display, organic light emitting diode and other display panel technologies. The company has boosted profitability in the current year to 15% (from 14%), and net income of $862.34 million is amply covered by operating cash flow of $2.43 billion. Return-on-assets of 4.28% is up from the prior year, as is the company's liquidity (current ratio of 1.44). Leverage is modest (long term debt represents only 12% of assets).