By Joseph Hogue CFA
The movie adaptation of Michael Lewis’ book, “Moneyball” comes out today to what will surely be big box office bucks (if advertising is any indication). The book is based on the front office career of Oakland A’s scout Billy Beane. Around 2002, Beane adopted Bill James’ Sabermetric approach to recruitment in order to help the team compete against teams with upwards of three times their salary power. Not able to recruit the big name athletes, the A’s had to find undervalued players. They did this by using statistical analysis of uncommon metrics, but ones with higher correlations to career success in athletes, than the more traditional metrics like stolen bases and RBIs.
The movie is sure to be a feel good romp about an underdog story and determination. What most will never know is that the book, “Moneyball: The Art of Winning an Unfair Game,” was written by one of the great financial journalists and has significant importance for investors. Those of us without the money power of institutional investors would do well to learn something from Mr. Beane and the Oakland A’s.
Sabermetrics places emphasis on in-game statistics rather than the industry norm of career averages. Key metrics include: "late-inning pressure situations" (LIPS) and my favorite "narration, exposition, reflection, description" (NERD). What is important to investing is the idea that many measurements, i.e. price-to-earnings, debt-to-equity, and earnings per share are so popularized as to be commoditized and of relatively little value. To compete with the institutional players, investors must look deeper into stock metrics to find measures more highly correlated with success and less often used. To this end I will present two methods of measurement not universally used and with proven success.
The first method will be the Piotroski Score, named after the University of Chicago Professor, Joseph Piotroski. Piotroski argued that because value stocks are often distressed companies, investors should implement a way to distinguish between companies with good future potential and those more likely to be value traps. The scoring is built on a series of nine criteria for evaluating a firm’s financial strength. Over a 20-year test period, those stocks scoring highest also outperformed a portfolio of all value stocks by about 7.5%. Additionally, those stocks scoring lowest were up to five times more likely to file bankruptcy or de-list their shares. Piotroski immediately came to mind when I first saw the commercials for "Moneyball." Both the movie and the method involve finding undervalued picks with a good future. Both Sabermetrics and the Piotroski Score look at ‘in-game’ (financial statement) statistics instead of getting caught up in the more popular relative valuation methods.
The scoring is fairly simple and straightforward with one point given for each of the following criteria:
- Positive prior year net income.
- Positive prior year operating cash flow: This is a better gauge of income and less susceptible to management manipulation.
- Current year return-on-assets is greater than prior year: A good measure of profitability.
- Prior year operating cash flow exceeds net income: A warning sign of income statement manipulation by management is net income that significantly exceeds operating cash flow. Managers can manipulate accounts to show higher net income, but it is much harder to manipulate actual cash flows.
- Ratio of long-term debt to assets is lower than prior year: Lower liabilities relative to assets is a sign of improving financial stability.
- Increasing current ratio (current assets divided by current liabilities): This is a signal of improving access to working capital and solvency.
- Number of shares outstanding is equal or lower than prior year: An increasing number of shares outstanding means that prior investments are being diluted.
- Current year gross margin exceeds prior year: Margins measure the company’s competitive position.
- Percentage increase in sales exceeds percentage increase in total assets: An improving asset turnover means the company is improving productivity.
DR Horton (DHI) and Dell Inc. (DELL) both did well in a Piotroski screen with top scores of nine. DR Horton is a $3.1 billion homebuilder operating in 26 states. Its stock price has been pressured along with the rest of the homebuilders, losing 11.4% over the last twelve months. Eighty-seven percent of the shares are held by institutions and 12.5% are held by insiders making the float relatively limited. Another 26 million shares are sold short, about 11.2% of float, meaning there could be some support as short-sellers return to buy back their positions.
Dell is the $27 billion computer-maker and retailer that was once the darling of wall street and the kind of stock that made you rich. In the ten years to 2000, the stock price increased by 846 times, but has not been able to catch a break since. The stock is up 14.7% over the past year but still off 15.1% from its July highs. The company’s CEO, Michael Dell, recently told Bloomberg that they would continue to look for 8-10 acquisitions per year of companies with proven technologies. The stock price is relatively cheap at only 8.0 times trailing earnings though return on assets is fairly low at only 7.5%.
Big Lots (BIG) and Eastman Kodak (EK) did not do as well on the screen with scores of 0 for Big Lots and 3 for Eastman Kodak. Big Lots operates a chain of cost-leader retail stores across the 48 contiguous states and 88 stores in Canada. Though the stock has been supported over the last few years as a low-cost retailer, lowered expectations on economic growth and a generally tired consumer are holding the company back. The stock, at $33.62, is up 1.4% over the year but well off its highs of $43.68 per share.
Eastman Kodak, that once great camera company is now only a $700 million shell of its former glory. The company operates in three segments: consumer digital imaging; graphic communications; and film, photofinishing, & entertainment. Looking over the financial statements is depressing with negative profit margins, return-on-assets, and cash flow. The stock is down 38.7% over the last year and has a negative book value when goodwill is backed out.
The Altman Z-Score is similar to the Piotroski Score in that it is a predictor of financial distress and used primarily in value investing. The method, published in 1968, was named after Professor Edward Altman of New York University. It uses five ratios, multiplied by a coefficient for weighting of importance, to predict the likelihood of bankruptcy within two years. The model was found to successfully predict 72% of corporate bankruptcies two years prior to filing chapter 7 and only falsely predicted bankruptcy in 6% of cases. Subsequent studies have found the method to accurately predict distress 80-90% of the time with 15-20% false predictions (pdf).
The five ratios and their coefficients are:
- Working Capital/Total Assets (1.2): Measures liquidity of assets and the financial flexibility of the firm.
- Retained Earnings/Total Assets (1.4): A measure of profitability relative to the company’s size.
- Earnings Before Interest and Taxes/Total Assets (3.3): A measure of operating efficiency outside of tax and debt considerations.
- Market Value of Equity/Book Value of Total Liabilities (.6): It is a possible warning signal when the market value of the firm is substantially below the book value.
- Sales/Total Assets (1.0): A measure for total asset turnover and efficient use of firm assets.
The scores for each ratio are then summed and interpreted as follows:
- Score>3.0 - The company is safe based on financial figures.
- 2.7><2.99 - The company is on alert and investors should be cautious.
- 1.8><2.7 - There is a good chance the company will file bankruptcy within two years.
- Score<1.8 - The probability of the company filing for bankruptcy within two years is high.
One notable Altman Z laggard is media conglomerate Time Warner Inc. (TWX) with a score of negative .50 and a high probability of financial distress. The company trades for a persuasive price-to-earnings growth (PEG) ratio of just .78 and an even price-to-book value. The stock is only off 3.6% over the last year but has traded flat since 2002 and is off its 2007 highs by more than half. Media companies have had a tough go of it lately as more content goes to the internet and traditional media loses advertising revenues. Though the company’s margins and revenue growth are in-line with industry averages, a deeper look into the financial statements presents a possible unstable future.
There is some redundancy between the two measurements and not much research as to which is the better predictor. They are relatively easy to calculate and an Excel spreadsheet template makes the process even faster, so I use both for my value investments. Stocks scoring well on both metrics usually make the cut for value picks, while those scoring well in one but not the other would need further scrutiny. A note of caution, I’ve found several screens on the internet that give different scores for the same stock so you will want to take the time to dig into the financial statements and do the actual scoring yourself.
Adapt or Lose Money
Another key take-away from the book is the idea of adaptation to market efficiency. The success of the A’s Sabermetrics approach brought imitators and competitors in the field. Today, most big league teams have a staff of statisticians analyzing a slew of data. To continue their run, the A’s had to continuously search for neglected metrics that would correlate with success.
This is just as true in investing. The first guy to discover the January Effect probably made some good money. The millions of investors that have tried the approach since then haven’t fared as well. As soon as a metric or strategy is popularized, the market starts pricing for it and the easy money is gone. Investors must continuously adapt their strategy to stay one step ahead of the market.
Investing, like professional baseball, is an extremely competitive field. Those that do not spend the time to find novel and superior analytical tools will be fodder to the big dogs, i.e. the Detroit Tigers. Further, without an analytical staff to back our stock picks, regular investors like you and me need to analyze and adapt our strategies continuously to gain those coveted few percentage points above the index. The two measurement tools above will help to assess financial stability and solvency, but you’ll need a few other predictors to build out your toolbox.