Created by accounting professor, Joseph Piotroski, the Piotroski F-Score is a system that uses nine criteria in the areas of profitability, capital structure/financial liquidity, and operating efficiency to decide whether or not a stock has solid financials, and if those financials are getting better. For each criterion that a stock passes it gets one point, so at the end the stock has between zero and nine points (its "F-Score.") In the original system, a stock that had an F-score of eight or nine would pass, and so was considered financially strong and would be expected to perform well in the future.
I built a screener in Stock Rover that screens for stocks that would have a score of nine-that is, the passing stocks meet all nine criteria (you can download this screener with a Premium membership or free Premium trial of Stock Rover). Initially Piotroski developed this screener to apply to value stocks, in order to separate the value stocks with poor financials from those with strong ones. My screener does not select for any value criteria, but you can feel free to add some if you are interested in value stocks. In general, the Piotroski screener may have a slight intrinsic bias for value stocks, as high-growth companies may fail on the Cash Flow and Share Dilution criteria (explained below in numbers 2 and 7, respectively).
In this article, I'll discuss the theory behind the criteria of the screener, show how this screener has performed when backtested (spoiler: it performed really well), and show and discuss the stocks that currently pass the screener, as well as patterns in the sectors of the passing stocks.
Here are the nine criteria that are used in the screener, and why.
1. Return on Assets > 0
Return on Assets (ROA) is calculated by dividing Net Income by Total Assets, so this in effect measures if the company had positive net income (or profits). It's a straightforward test: financially sound companies should be profitable.
2. Cash Flow > 0
Cash flow is another (and many believe better) way to gauge earnings, and measures how much money is going in or out of the business. A positive cash flow ensures that the company is generating enough cash from day-to-day operations in order to continue its day-to-day operations. A firm can have a positive net income but negative cash flow, which is why this criterion is included on top of ROA>0. Additionally, cash flow is harder to manipulate under GAAP than Net Income is.
3. Return on Assets > Last Year's Return on Assets
This equation measures whether or not the firm is improving its profitability. If the company was less profitable this year than last, it could signal that there are financial troubles to come.
Cash Flow > Income After Tax
This equation also measures profitability and is meant to weed out any stocks that may be playing accounting tricks in order make their earnings appear larger than they are. Because income has had taxes and depreciation subtracted from it, cash flow is generally larger than income. If it's not, then it means that the firm may be shifting earnings forward, thus misrepresenting them in the long run.
5. Long-Term Debt/Total Assets [now] < Long Term Debt/Total
Assets [1 year ago]: This ratio targets capital structure. Piotroski was looking for stocks that were decreasing their debt, increasing their assets, or both. In other words, cases where the ratio of long-term debt to total assets would be decreasing. Taking on more debt, while not an inherently bad sign, increases its financial risk and may signal that the company is not generating adequate cash flow.
6. Current Ratio [now] > Current Ratio [1 year ago]
The Current Ratio is the Current Assets divided by Current Liabilities, and is used to gauge the liquidity of the firm. If a company is liquid, then it can easily pay its debts. The higher the ratio, the more liquid the firm (though if it's too high, that can signal other issues, like an inefficient use of capital.) Like every accounting ratio, this one does not tell the whole story, but by requiring an improving current ratio, this criterion ensures that passing companies will have an increased ability to meet its financial obligations.
Pause: what's the difference between #5 and #6?
At this point, you may be saying, #5 and #6 deal with assets and liabilities, so why are they both needed? Essentially, they deal with different timelines of financial security. Criterion #5 (Long-Term Debt/Total Assets) looks at a longer time line, and thus deals with solvency, whereas criterion #6 (Current Assets/Current Liabilities) uses a shorter timeline, and thus deals with liquidity. A solvent firm has a positive net worth, whereas a liquid firm is able to pay all of its current bills, and both are important for financial health.
A company can be solvent (total assets greater than long-term debt) but still have a liquidity problem, meaning it doesn't have enough cash (or easily sellable assets) on hand in order to pay its bills. However, because a solvent company has a more manageable debt load, it's better able to borrow against its assets to raise cash in the short term. On the flipside, a company can be insolvent (long-term debt greater than assets), but still have enough cash or liquid assets on hand to meet all its short-term obligations. While this company would be able to carry on with business as usual, it could be headed for financial distress further down the road. Piotroski was looking for companies that had a low degree of financial risk in both the short and long runs, which is why both criteria in #5 and #6 are included.
7. Shares [now] < Shares [1 year ago]
This criterion also targets the capital structure by only letting in companies that have not issued any common stock in the past year. In addition to reducing the value of an investment, share dilution can signal that the company can't cover its current liabilities, which is another sign of financial distress.
8. Gross Margin [now] > Gross Margin [1 year ago]
Gross Margin (or Gross Profit Margin) is the percentage of revenue that's left over after paying the costs of producing the goods sold. By weeding out companies that weren't able to increase their gross margins in the past year, this criterion selects for companies that are becoming more efficient and thus are expected to be more profitable.
9. Sales/Total Assets [now] > Sales/Total Assets [1 year ago]
The final criterion in Piotroski's score screens for an increase in Sales/Total Assets, also known as asset turnover. An increasing asset turnover ratio signals that the company is able to generate more sales with their assets, and thus is also a measure of efficiency.
Pause: what's the difference between #8 and #9?
Screening for an increasing gross margin ensures that the company is able to keep costs under control, whereas screening for increasing asset turnover ensures that the company is able to grow their sales relative to their assets.
About the Screener's Structure
It's important to note that rather than screen for stocks against a hard value (Gross Margin > 10%, for example), most of this screener's criteria compare metrics against their values from a year prior. This is advantageous because many metrics have wildly different ranges depending on the industry or sector of the company, but by using criteria based on relative values, this screener is able to pull from all corners of the market.
Also note that stocks that do not pass the above criteria are not necessarily financially unsound - for example, strong companies that are investing in growth may not pass - but this screener is taking no chances.
The logic behind this screener seems reasonable: financially healthy companies perform better. But is it true? To check, I created a "backtest" screener in Stock Rover, using all the same criteria from above, but using data from five years ago. So, for example, the criterion for #8 would be Gross Margin from five years ago > Gross Margin from six years ago. I then ran that screener, saved all 87 stocks as a watchlist, and charted it (including dividends). Here's what I found:
Let's see that again, this time with the S&P 500 set as a baseline:
Wow! This must be the reason that the Piotroski F-Score is so famous. While the S&P was up 90.5% in the past five years, the Piotroski almost doubled that at 172.6%. That means it outperformed by 82.1%!
But if we step back a bit, this all makes sense. All of the Piotroski criteria target stocks are increasing their profitability, increasing their efficiency, and reducing their debt. More efficiency means more profit, and more profit means higher earnings, and those are rewarded with a high stock price. Combine this with improving capital structure, and you have all the workings of a fundamentally strong company. Of course, I always recommend that you do your homework on any stock you find from a screener before investing capital, but this screener will certainly give you a great head start.
The top performing stock in the backtest was Rockford (OTCPK:ROFO), a micro cap tech stock that produces audio systems, with an outperformance of 1990%. Micro caps are high risk, but, case in point, can bring a hefty reward. The second best out-performing stock was Chipotle (NYSE:CMG), a Stock Rover darling from 2012.
While the screener performed overwhelmingly well on the whole, some of those Piotroski-approved financially strong companies weren't able to keep up their price performance. At the bottom of the pack we see a few stocks that did poorly, with returns ranging from slightly negative (Franklin Wireless (OTCQB:FKWL) with a 5-year total return of -2.5%) to extremely negative (Education Management (NASDAQ:EDMC) with a 5-year total return of -95.8%). Both of these stocks are micro caps, and in fact, most of the stocks that did poorly are micro caps (of course, some of the stocks that did well are also micro caps - that's micro caps for you). You can always filter micro caps out of your screener if you are not interested in them, which is what I do later in this article.
Some other notable large cap mentions from the backtest that did well in the past five years are: VF (NYSE:VFC), Visa (NYSE:V), ConocoPhillips (NYSE:COP), Roche Holding (OTCQX:RHHBY), and Chevron (NYSE:CVX). In general, the stocks performed better over a longer period than over a shorter time period.
If you'd like to take a closer look at all of those 87 stocks, they are available to download as a free watchlist from the Stock Rover library.
Now let's look at results I get when I run this screener on current data. Of the nearly 8,000 stocks on the North American exchanges, I get 54 stocks that pass. However, 14 of them have been public for less than 5 years, so I'm going to kick those ones out because I'd like a longer track record of data, so that gives me 40 stocks. Remember, these 40 stocks all have an F-score of 9, but that's all we know about them.
When I chart these 40 stocks collectively against the S&P 500 over a 5-year period, here's what it looks like:
Overall, these 40 stocks have outperformed the S&P 500 in the past five years, though it looks like they've been hit harder in the past couple of weeks with the recent downturn in the market. Remember, the screener does not incorporate any price performance or momentum metrics, but instead aims to find fundamentally strong stocks that will ultimately weather this storm and others.
Let's look at the past performance of stocks that have passed. Going from left to right in the table below, the columns I've included are sector, market cap, and P/E Sector Decile (which compares the P/E of the stock to those in the same sector - companies that are cheapest in their sector by this valuation score a 1 and those that are the most expensive score a 10). Then there's the 5-year total return, the 5-year return versus the S&P 500, and the 5-year total return versus sector - then those same three return metrics for the 3- and 1-year time periods. I've sorted the results by 5-Year return versus S&P 500 in ascending order (the column header for this metric is highlighted blue below.)
Right now, I'm just looking at the overall pattern of red and green to see if anything jumps out, not at the specific stocks. The 5-year metrics are on the left, with the 3-year and then 1-year metrics listed to the right.
From a bird's eye view, it's clear that if a stock had red in the 5-year returns (left side), it was more likely to stay red in the shorter time periods (right side).
It's also clear that some stocks that underperformed the S&P (red in the second colored column) still outperformed their sector over a 5-year period (green in the third colored column), meaning they could still be strong candidates within their sector, it's just that the sector isn't doing as well as the S&P. In fact, let's just group them by sector and see if we see a pattern. At this point, I'll only focus on the 5-year return, as the backtest showed us that this is better as a longer-term strategy, so I'll get rid of the 1- and 3-year return metrics.
Screener Results by Sector
Now let's go over the 40 stocks sector by sector to see if there are patterns. I will use market cap, P/E Sector Decile, 5-year Return, 5-Year Return versus the S&P, and 5-Year Return versus their sector.
The stocks in Basic Materials and Communication Services, shown above, outperformed their sectors, but underperformed the S&P, so it's clear that it was the sector's problem, not the stocks.
Consumer Defensive tells a similar story, but with one of the three stocks, Orkla (OTCPK:ORKLY) doing (very) poorly:
Consumer Cyclical is the opposite - below you can see from the similarity between the 5-year Return vs. the S&P and the 5-year Return vs. Sector that Consumer Cyclical sector had a similar return to the S&P in the past five years.
However, all but one of the Consumer Cyclical stocks, Graphic Packaging Holding Co. (NYSE:GPK) found through this screener underperformed both their sector and the S&P 500 in the 5-year time period, and we have another micro cap, Blue Nile, Inc. (NASDAQ:NILE) with the worst performance. Despite the fact that the Piotroski typically finds strong companies, given this information I may stay away from the stocks it gives me from the Consumer Cyclical sector.
The Energy stocks, below, are a mix - the sector as a whole underperformed the S&P, and while CVR Energy (NYSE:CVI) shot the lights out with a 5-year return of 336.3%, the other stocks in this sector, both mid and small cap, are underwhelming.
Financial Services, below, is polarized, with one stock, Affiliated Managers Group (NYSE:AMG) doing really well and one, EZCORP, Inc. (NASDAQ:EZPW) doing really badly; Healthcare, also below, is similar: CSL Ltd. (OTCPK:CSLLY) handily outperformed its sector and the S&P, but Merit Medical Systems, Inc. (NASDAQ:MMSI) was down 6.5% in the past five years, and down 97.4% from the S&P.
It's interesting to note that both the poorly performing stocks in Financial Services and Healthcare are micro caps - so there's the high risk but without the hefty reward that we saw from Rockford. On the flipside, the stocks that did very well in these sectors were both large cap.
Six of the eight stocks in Industrials outperformed the S&P, even while the sector underperformed:
This leads me to believe that the Piotroski could be used to find strong Industrials stocks. Of the two that underperformed, Cardno Ltd. (OTCPK:COLDF) came in a little under its sector and a lot under the S&P, and Checkpoint Systems Inc. (NYSE:CKP) did very badly against both benchmarks. Additionally, both of these underperformers are on the smaller side, and is another micro cap whose price performance has failed spectacularly.
And in Real Estate...
Only one Real Estate stock passed, Corrections Corporation of America (NYSE:CXW) and it outperformed its sector over the past five years by 17.9%, and came in just a hair over the S&P. With a sample size of one, I'm not comfortable extrapolating that to any larger trend about the sector as a whole, but I'll take note that it's a mid cap.
Lastly, Technology ends up looking pretty good in this screener:
Though the sector itself underperformed the S&P over five years, four of the six tech stocks outperformed the S&P, so perhaps the Piotroski screener has a nose for good tech stocks.
Now that I have the general rundown of the sectors, I'll try to find specific stocks that look like they'd warrant more investigation. First, I'll filter out any of them that didn't outperform their sector over the past five years, which knocks out 17 stocks and brings it down to 23. There are also some really little guys in there, so I'll remove any stock that has a market cap below $500 million - they're a little too risky for my taste and the backtest showed that micro caps from this screener were more likely to underperform. That brings it down to 20 stocks. Lastly, I've sorted it by Price/Earnings Sector Decile so I can see which stocks look like good values within their sectors.
In this view, we can see that we have a range of valuations. There are some cheap stocks, like CSL , that have done really well against their sector and the S&P in the past five years, but are still cheap in their sector. There are also some expensive stocks, like Premiere Global Services (NYSE:PGI) (highlighted) that are more expensive but haven't done well against the S&P 500 - in fact, it barely squeaked by when I screened out stocks that didn't outperform their sectors.
Based purely on valuation (cheaper than the median in their sector) and performance (strong outperformance of both the S&P and their sector), I'd be interested in diving deeper into the following stocks (in no particular order):
- IAC/InterActive (IACI)
- G&K Services (NASDAQ:GK)
- Rockwell Automation (NYSE:ROK)
- Matrix Service (NASDAQ:MTRX)
- CVR Energy
- Idex (NYSE:IEX)
- iGate (NASDAQ:IGTE)
- Constellation Software (CSU.TO)
- Verisk Analytics (NASDAQ:VRSK)
- TIBCO Software (NASDAQ:TIBX)
- Corrections of America
There are many more ways to slice and dice these results, and this article only takes a largely aerial view of the stocks as a whole. However, I believe that recognizing overall patterns in the screener results can better inform how to proceed with further research.
Based on the backtest, I'd stay away from a stock that's been underperforming in the past - even with the strong financials that the Piotroski screener demands, they're not enough to predict a turnaround with a chronically weak stock.
Additionally, the Piotroski seems to be a more reliable indicator for mid to large-cap stocks. A majority of the stocks that performed the worst were micro caps. The stocks found by the screener in Basic Materials, Communication Services, Industrials, and Technology generally outperformed their sectors. Stocks found in Consumer Cyclical appeared to be weaker.
If you use Piotroski results and weed out the underperformers and the expensive stocks, you should still be left with a handful of solid stocks with which you can do more in-depth research.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.