Piotroski Strategy Nets Big Gains Through Downturn

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 |  Includes: BBL, CTB, KODK, SGY, TII
by: John P. Reese

The American Association of Individual Investors (AAII) recently published its 2008 stock screening review ($$). For those that may not know, AAII has been tracking the performance of its screens since 1998. Through December 5th, the median performance for all of the AAII strategies was -41.7%. But, there was one strategy that was positive. And not only was it positive, but, amazingly, it was up 32.6% for the year through the start of December. I found this totally mindblowing, and as I looked into this in more detail I realized that the strategy was the same as one of the models we run on Validea.com.

What strategy was it? The quantitative approach based on the investment method developed by Joseph Piotroski while he was an accounting professor at the University of Chicago.

What I also uncovered is that since the November 20th low, my Piotroski based approach has put up over 51% through January 16, 2009. Think about that — AAII’s model put up 32.6% in 2008 and Validea’s Piotroski 10-stock portfolio is up over 50% since the November low. Pretty impressive performance. My 10-stock Piotroski portfolio has also fared far better than the broader market since I started tracking it on Feb. 24, 2004, losing just 4.5% while the S&P 500 has lost 25.9%.

But before you go all in on the Piotroski approach, it’s important to look at a few other things. First off, AAII’s approach, unlike Validea’s approach, requires that stocks pass all of a strategy’s criteria, and if it doesn’t, they will not invest. According to AAII, “the [Piotroski] approach has generated no passing companies for each of the last four months. As a result, this screen’s strong 2008 performance came from holding only a handful of companies, while also sitting on the sidelines during the recent market collapse.”

Validea’s models are constructed differently. First off, we have created a ranking system that will rate the stocks using each strategy. As a result, our models will always be fully invested. Secondly, we have liquidity requirements layered into our portfolio construction process so that the model can be realistically invested in without impacting the price of the securities that are being bought and sold.

As a result, the underlying positions in the AAII and Validea.com Piotroski portfolios will vary significantly. AAII’s portfolio looks to have small- to micro-cap firms, while Validea’s model holds small- (mostly), mid- (some) and large-cap names (few of these). But despite these differences, both portfolios have generated good, but different, returns over the years. AAII’s performance goes back to 1998, while Validea’s portfolios started on July 15th, 2003. The table below provides the of AAII and Validea’s models vs. the S&P 500.

click to enlarge images

Piotroski Strategy PerformanceClick to enlarge

Despite the differences in portfolio construction, the underlying variables that the strategy looks at are the same. The approach begins by looking at the bottom 20% of the market based on Price/Book ratio (this is the same as firms with high Book/Market ratios). Piotroski found that just buying low Price/Book stocks does not produce excess returns over the long term, however, because many low Price/Book companies are trading at a discount because they deserve to. Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. I’ve listed the 10 criteria below.

  • Book/market ratio
  • Return on assets
  • Change in return on assets
  • Cash flow from operations
  • Cash compared to net income
  • Change in long-term debt/assets
  • Change in current ratio
  • Change in shares outstanding
  • Change in gross margin
  • Change in asset turnover

Also, I’ve included the top five current holdings in the Validea.com Piotroski portfolio. These are the stocks in our monthly rebalanced portfolio. The next portfolio rebalancing will take place on January 23, 2009 and at that time the stocks will either be held on to or sold.

Piotroski Picks

Disclosure: At the time of publication, John Reese and his private clients of Validea Capital Management were long all stocks mentioned in this article.