A smarter way to find value

One of the biggest mistakes an investor can make is paying too much for a share. This often happens because the company can't live up to the lofty expectations that the market is already pricing in.

To avoid this risk, noted value investor Benjamin Graham advocated a strategy of buying very cheap stocks. He reasoned that these shares were so depressed that there was little expectation of things getting better. But if they did, he stood a good chance of making money.

There are many ways to identify cheap stocks. One popular measure is to compare the share price with the firm's net asset value (or book value) per share. The aim is to buy shares at a big discount to their book value. But is such a simple strategy the best one?

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Piotroski's insight

A 2002 study by Chicago University accounting professor Joseph Piotroski suggests not. Piotroski found that buying shares with a low price-to-book-value ratio (p/b) produced results that were not as good as they could have been.

Many firms with low p/b values are financially distressed and their business continues to deteriorate. The performance of these shares detracted from returns from cheap companies in better financial health and reduced the overall returns of a low p/b portfolio.

Piotroski set about finding out whether he could improve these results by filtering out the worst companies. He devised nine tests of financial strength, giving companies one point for each test they passed.

The results were added together to give what is known as an F-Score. High F-Scores (between seven and nine) were seen as a sign of improving financial health.

Piotroski backtested a strategy ofinvesting in shares with low p/b values and high F-Scores. He found that itwould have returned an extra 7.5% per year between 1976 and 1996, compared to just using valuations alone.

The strategy worked best with small and medium-sized firms with low trading volumes and with no stockmarket analysts following them.

Calculating an F-Score

So how does it work? The first four tests focus on profitability and the ability to generate cash. Each test passed scores one point towards the F-Score:

1. Return on assets (net income/total assets) is positive.

2. Return on assets is improving compared with the previous year.

3. Cash flow from operations is positive.

4. Cash flow from operations is greater than net income. (It is harder to fake cash flow than profits.)

The next group of three assess the ability of a company to meet its financial obligations. One point is awarded for passing the following tests:

5. Leverage is decreasing compared with the previous year. Here, leverage is measured by the ratio of long-term debt to average total assets.

6. The current ratio (current assets divided by current liabilities) is rising compared to the previous year. This tests the firm's liquidity (the amount of cash and short-term assets it has on hand to meet near-term obligations).

7. The company has not been a net issuer of equity in the past year. Issuing shares to raise capital can be a sign that a company is struggling to generate cash internally.

The last two tests are based on the company's operating efficiency. Again, one point is awarded for passing each test:

8. Increase in gross margin (gross profits/turnover) compared to the previous year. Higher profits are better than lower ones.

9. Increase in asset turnover (sales/total assets) compared to the previous year. This shows that a firm is getting more out of its asset base and becoming more productive.

Add these up to get the total F-Score. It is not intended to be used alone, but as an add-on to a value screen, such as low p/b.

Eight cheap-looking stocks with high F-Scores

To show how you might use the F-Score in practice, I've run a screen to look for shares outside the FTSE 350 that have a p/b of less than one and a F-Score of seven or more. (Piotroski found the strategy worked best with smaller stocks that have little analyst coverage.)

These shares might be worth a closer look and a bit more homework. But bear in mind that a screen is the start of an investment process, not the end.

Check whether the book values of these companies are reliable. Are they based on tangible assets rather than lots of goodwill? Do they stack up on other measures of value? And are the accounts believable?

Source: ShareScope