London-listed stocks have enjoyed mixed fortunes in 2011, with a bright start quickly unravelling over the summer as macro economic concerns damaged investor sentiment. With the FTSE 100 and FTSE AIM 100 both down substantially on where they were one year ago, investors seeking to find bargains face challenging questions. On the one hand, market declines are presenting apparently attractive opportunities to buy equities cheaply but on the other, in the light of the precarious economy, the task of selecting which stocks offer the best chance of gains over the medium term is all the more demanding.
For followers of Joseph Piotroski, a celebrated accounting professor at the Stanford Graduate School of Business, the conditions merit the use of a formula that has frequently helped investors identify opportunities in tough markets. Piotroski is behind the F-Score, a simple indicator to highlight stocks showing the most likely prospects for outperformance amongst a basket of apparently undervalued companies. He first outlined his theory in an April 2000 paper entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” Since then, it has won an army of followers and in the bear market of 2008, was hailed by the American Association of Individual Investors as the only one of 56 screening tools to produce a positive return for investors.
Piotroski’s starting point is a list of companies that are, on paper, the most undervalued on the market. You arrive at a list of “value” stocks by dividing what the market is pricing them at by what each company’s total assets are stated to be worth and concentrating on the cheapest 20% of companies. This price-to-book value list generally produces a collection of companies that, on a pure valuation basis, can appear to be mispriced. A quick scan of such a list will show that there may be very good reasons why investors won’t touch companies in this basket – they can often be financially stricken or even basket-cases.
The overarching question is however why each company is being undervalued and whether it is justified. It could be any number of factors including serial underperformance, financial calamity, investor ignorance, poor communications, an unsexy sector or an unappealing business model. Whatever it may be, these companies are out of favour and Piotroski’s theory seeks to pick the ones that offer the best chance of recovery as opposed to those that will continue to languish or fall further into distress. As with any value investing philosophy, the underlying strategy is to buy stocks at a cheap price relative to their intrinsic value.
To assess which companies are in the best financial shape Piotroski screens each stock using nine different accounting-based criteria – scoring one point for each “pass”. As discussed in detail here, the criteria are broken into three sections starting with profitability signals followed by leverage, liquidity and source of funds and, finally, operating efficiency.
The profitability signals begin with a straightforward question of whether the company has a positive net income. It will score additional passes for positive cashflow from operations and an improved year-on-year return on assets. Finally, if the cash flow from operations exceeds net income before extraordinary items the company will also score a point. Next, leverage, liquidity and source of funds. Here, if the company cuts year-on-year debt levels then it scores a point. It will also earn a pass for both increasing its liquidity ratio and for avoiding issuing any more shares. Finally, on operating efficiency, the company will be awarded a point if there is a year-on-year improvement in its gross margin as well as if there is a higher asset turnover ratio (as a measure of productivity).
By investing in companies scoring 8 or 9 by these measures, Piotroksi showed that, over a 20-year test period through to 1996, the return earned by a value-focused investor could be increased by an astounding 7.5% each year. In challenging market conditions such as those today where many companies have been forced to shelve investment plans and watch almost helplessly as margins have been squeezed, achieving a nine on Piotroski’s F-Score screen is a demanding task. Moreover, investors seeking to screen value stocks using Piotroski manually face considerable work. Nevertheless, using Stockopedia PRO to apply Piotroski’s thinking to the current market, we set out below five value stocks that look worthy of closer scrutiny (you can see the full list of stocks here by signing up to Stockopedia PRO).
The first in the list is International Greetings (LON:IGR), a company that designs and distributes gift cards, wrapping paper, stationery and accessories. International Greetings emerged in 2010 from two years of recovery and restructuring under the leadership of new CEO, Paul Fineman. With operations on four continents, the economic downturn was bad news for the company, which swung from a £17.7m profit in 2007 to a £3.1 million loss in 2008. Nevertheless, Fineman and his team returned the business to profit last year, reducing debt and focusing on expanding in international markets and relying less on the UK market, which had caused all the trouble in the first place. With a book value of £48.1 million against a market cap of £28.9 million and all the financial indicators going the right way last year, International Greetings scores a full nine points on Piotroski’s screen.
Next is house builder Persimmon (LON:PSN), which unsurprisingly suffered badly during the recession as falling mortgage approvals ruined the market for selling new homes. Pre-tax profits slumped in 2008 and 2009 and shares in the company collapsed from a five-year high of 1,373p in early 2007 to 185p by December 2008. In response, Persimmon focused its efforts on cutting debt, maximising cashflow and growing its land bank, which led to improvements, albeit modest, across the board in the 2010 figures. Shares in the group have been drifting along at just below 500p since mid-2009 in line with what appears now to be a more stable UK housing market. The company believes that overall growth in new home sales volumes will reflect developments in the wider economy. It is anyone’s guess how that might go but nevertheless, despite a book value of £1.7bn well above its market cap of £1.4bn, Persimmon scores an impressive Piotroski nine.
It was a similar story at Inland (LON:INL), the brownfield regeneration business run by former Country & Metropolitan boss Ian Wicks, which suffered like many others during 2008 and 2009. However, the company’s ability to negotiate the UK planning system has continued to see consents granted and building plots sold. Profitability returned in 2010 and the company has just announced even better results for the year to June. With profits up and debt slashed, Inland also scores a nine on the Piotroski screen. Since late 2009 shares in Inland have traded within a tight range of between 15.75p and 19p. At the current price of 17p, the company’s market cap is £30.4 million, well below its book equity of £48.5 million.
From real estate to counterfeiting – or anti-counterfeiting to be accurate; AIM listed technology company Opsec Security (LON:OSG) trades just short of its £30.7 million book value but has endured a bewildering year in 2011. American investment firm and existing shareholder Investcorp made an offer to buy it in April but the move was partially blocked by another institution, Herald Investment Management. With a 50% stake in the bag, Investcorp technically took control but didn’t have the 75% holding necessary to de-list the business. Apparently all parties are happy to continue with that arrangement and with a Piotroski score of nine, Opsec remains a candidate for further scrutiny on a value screen. Shares in the company more than doubled on the offer news in April but at 52.5p they remain well below their January 2007 high of 103p.
Finally, shares in FTSE Smallcap recruitment consultancy Harvey Nash (LON:HVN) reached a five year high of 93p in June but market volatility has since wiped 30p off the price. The global financial crisis caused a one-year blip at Harvey Nash, with its performance in the 12 months to January 2010 unsettling an otherwise impressive five year run. A return to form during 2010 helped the figures bounce back strongly and the share price responded accordingly during the first half of 2011. As a result, it hit all nine criteria on Piotroski’s screen. The company has a book value of £60.9 million against a market cap of £45.6 million. With indications that Harvey Nash is continuing to find its stride, the share price slump will be a source of frustration to CEO, Albert Ellis but perhaps an opportunity for investors.
It is important to remember that the F-Score is intended to identify a basket of value stocks that would outperform over the long-term, rather than being intended for use in individual stock-picking over shorter time-frames. And, of course, no screen is a substitute for careful individual research of a given company. Nevertheless, the market declines witnessed since the summer make the F-Score a hugely topical and interesting test to apply, especially for those focused on the value end of the market. As debate rages over where equities will go next, applying some robust yet straight-forward accounting checks on apparently mispriced stocks may offer insight into which companies could be the first to benefit when market conditions improve. As a reminder, you can see the F-Score of any stock plus track the performance of all high Piotroski stocks on the UK market by signing up here to Stockopedia PRO.