I wrote an earlier article on some of the top rated stocks in the S&P 500 index using the Joesph Piotroski inspired FSCORE system. Those stocks were fundamental buys. This article will deal with a list of S&P 500 candidates you may want to sell using this same theory.
The 9-Point Piotroski System
This simple accounting system for picking value stocks is based in strong and improving fundamentals. Of course, it works best with high market to book value stocks (or low P/B ratios). The theory and inner workings of his system can be viewed in this research paper (pdf).
The nine points that Piotroski ranked dealt with profits (such as return on assets), how these change over time, and cash flows. Then operating efficiency was analyzed, with changes in gross margin and asset turnover. Finally, liquidity and leverage was investigated by ranking changes in leverage, the current ratio, and if dilution of shares occurred as in new equity offerings.
Using this simple system, between 1976-96 he was able to generate 23% average annual returns, which was at least 7.5% better than the total value stock universe. He also shorted stocks that ranked very poorly with his system.
Of course, anyone who can generate these sort of gains is open to criticism of enormous proportions. Some claimed that his system did not pick better stocks on average, but that some error must have been made to include value stocks that went on to make abnormally high returns.
S&P 500 Underachievers
Piotroski had a two-prong investment system that he wrote about in 2000. First he bought stocks that ranked highly in his "strong and increasing" fundamental scan, and he shorted stocks that ranked poorly.
We will not go so far as to suggest shorting these S&P 500 stocks, but will only recommend selling them if you have read his paper and believe that his theory holds true. Which stocks in the S&P 500 rank poorly using his nine-point system?
- AK Steel (AKS)
- Allegheny Technologies (ATI)
- Baker Hughes (BHI)
- Electronic Arts (ERTS)
- Genzyme (GENZ)
- Huntington Bancshares (HBAN)
- Interpublic Group of Companies (IPG)
- Invesco (IVZ)
- Monster Worldwide (MWW)
- Omnicom Group (OMC)
- Roper Industries (ROP)
- Sprint Nextel (S)
- SCANA Corp. (SCG)
- Tesoro (TSO)
- MEMC Electronic Materials (WFR)
- Williams Companies (WMB)
- United States Steel (X)
Briefly Looking at a Couple Examples of Low FSCORES
United States Steel has negatives across the board when it comes to profit margin, operating margin, return on assets and equity, gross profit, and net income. The debt ratio is very high. The book value is under 2, since this stock is being hammered. The high short ratio of 16.6% is deserved. Negative earnings surprises have been the three-quarter norm.
MEMC Electronic Materials is plagued by missing EPS estimates for the last three quarters as well. While it expects a massive turnaround with quadruple digit EPS growth this quarter, and 500% growth next year, the past five years of negative 35.56% growth provides lingering doubts. Also, with a PE over twice the Industry average, this is already highly valued. The PEG is not low with 1.91 and average analyst consensus seems to suggest holding. Although it has a marginally positive profit margin slightly below 1%, the operating margin is negative, as is return on assets. It also carries substantial debt which will prove troublesome if markets decline.
Not everyone will agree with this type of fundamental scanning, just as I imagine recommending to sell some of their S&P 500 holdings will seem unsatisfactory to some. After performing due diligence and reading up on how the FSCORE system works, you may want to consider selling off these stocks, or at least putting in well-calculated stop-losses. Keeping a close eye on how the S&P 500 reacts as it nears the 1300 resistance (breakout stocks listed here) will provide other trading suggestions.
Stay tuned, as in the future I will combine this strategy with momentum investing for a statistically improved result borne out in published research papers.