A Review Of The Piotroski Book/Market Model

Summary

• "Quant" strategies are all the rage with investors, but not all quantitative strategies are new breakthroughs.
• Joseph Piotroski developed and tested a quantitative model in 2000 that showed back-tested returns of 23% annually from 1976-1996.
• Concentrated value models, like Validea's Book/Market based on Piotroski's screen, have potential for outperformance and the recent bout of value stock underperformance is why this model has potential going forward.

Quantitative investment strategies have drawn a lot of headlines and attention in the finance world, and represent an arm of passive investing which continues to rule the market roost. Since 2009, the flow of funds into the "quant" sector has more than doubled, and a number of high-profile money managers are bulking up their quant teams and relying more heavily on computer algorithms for stock-picking.

The concept, however, isn't new.

Joseph Piotroski Ph.D., an accounting professor at Stanford University (and a market guru that inspired one of the stock screening models I created for Validea), has largely flown under the investing world radar, but has been front and center in the evolution of quantitative value investing models. Back in 2000, while teaching at the University of Chicago, he wrote an academic paper on equity investing that took Wall Street by surprise. His research focused on companies with high book-market ratios—the type of unpopular stocks whose book values (equal to total assets minus total liabilities) were high compared to the value investors assigned them (measured as market capitalization, the share price multiplied by number of shares outstanding).

There was little glamour or pizzazz in Piotroski's research findings. The consummate number-cruncher, he used a series of accounting-based measures to develop a model that would identify high book-market companies that were likely to become winners. And his paper, published only one year after he started teaching, was full of mathematical, statistical and accounting terms that would cause many a lay investor's eyes to glaze over. But the proof was in the pudding or, in this case, the balance sheet. Piotroski's study found that buying high book-market firms that passed his tests (and shorting those that didn't) would have produced a 23 percent average annual return from 1976 through 1996 –more than double the S&P 500's gain during that period.

While Piotroski, who once characterized himself as a "value investor at heart," wasn't the first to focus on high book-market stocks. His research went deeper than previous studies in that it worked toward carving out those companies that sported high book-market ratios due to underlying financial distress. The key to improving investor returns, he argued, was to identify companies that were being unfairly judged and were therefore overlooked by Wall Street. To accomplish this, he used a series of balance sheet-related criteria targeted in three main areas:

• Profitability: Piotroski looked for companies with positive operating cash flow that was greater than net income, to ensure that a business's profitability is not due to a one-time event but rather originates from its operations.
• Financial leverage/liquidity: This category relates to changes in a company's capital structure and its ability to meet future debt service obligations. Piotroski assumed that any increase in leverage, deterioration of liquidity, or use of external financing was a red flag.
• Operating efficiency: This includes measures of how a company is using what it has to make money and grow its business.

Although value strategies have been lagging growth in recent years, trends such as these move in cycles and will eventually revert. No investment strategy—or share price, for that matter—moves in one direction indefinitely. What works well in one market environment could fall very short in another, and vice versa. The key for investors is to protect themselves against these cycles—as best they can—by constructing a diversified portfolio that will be able to weather the vagaries of the market and hopefully minimize distress for the investor.

On Validea, I've been tracking a Piotroski long-only model since 2004 (20-stock portfolio rebalanced annually) and the performance is highlighted below. A few things stand out. The model was a bit slow out of the gate during the period from 2004-2008, but following the end of the 2008/2009 bear market the portfolio had a massive move - returning over 72% in 2009 and 67% in 2010. In 2013, the portfolio was up over 35%, but since 2014, the strategy has fallen out of favor and so far this year it trails the market as well. These concentrated value models can be quiet risky, but as the return history shows the long-term potential is significant, and when value stocks are in favor an approach like this can certainly produce alpha.

Using the stock screening models I created based on the investment philosophy of Piotroski and other market greats, I have identified the following high-scoring stocks:

Tropicana Entertainment (OTCQB:TPCA) is an owner and operator of regional casino and entertainment properties located in the U.S. and a hotel, timeshare and casino resort located on the island of Aruba. The company earns a perfect score under our Piotroski-inspired investment strategy due to its position in the top 20% of the market based on book-market ratio (0.89), its return-on-assets of 3.12% and operating cash flow of $133.73 million. It also earns high marks from our Peter Lynch-based screen for its ratio of price-earnings to growth in earnings-per-share (PEG ratio) of 0.36, which is considered very favorable. Our Kenneth Fisher-inspired investment strategy likes the company's price-sales ratio of 1.22, which falls comfortably within the preferred range of between 0.75 and 1.5.

Vale SA (VALE) is a global producer of iron ore and iron ore pellets, key raw materials for steelmaking, and a producer of nickel. Our Piotroski-based model likes the company's return-on-assets of 3.35% as well as its operating cash flow of $6.5 billion, and our Lynch-based screen favors the PEG ratio of 0.24. The company's rising trend in earnings-per-share over the past 2 quarters earns high marks from our David Dreman-inspired investment strategy.

Telefonica Brasil SA (VIV) is a mobile telecommunications company in Brazil that is favored by our Piotroski-based screening model for its book-market ratio of 0.93 as well as its operating cash flow of $3.5 billion, which exceeds the most recent year's net income, a plus under this model. The company also passes our Dreman-based screen due to its price-cash flow, price-book value and price-dividend ratios, all of which fall within the bottom 20% of the market.

Mitsui & Co. Ltd. (OTCPK:MITSY) is engaged in the product sales, logistics and financing, as well as the development of international infrastructure and other projects. Our Piotroski-based screening model favors the company's upward trend in liquidity (current ratio rose from 1.67 to 1.77 in the most recent year) and increase in gross margin over the same period, from 15.0% to 16.0%. The company's book-market ratio of 1.33 is also considered favorable by this model.

Genesco Inc. (GCO) is a wholesaler and retailer of footwear, apparel and accessories that earns a perfect score under our Benjamin Graham-based investment strategy in light of its liquidity (current ratio of 2.53) and its long-term debt which, at $136.4 million, is considerably lower than net current assets ($447 million), a plus under this model. Our Piotroski-inspired model favors the company's book-market ratio of 1.35, which falls in the top 20% of the market, and the return-on-assets of 6.69%.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long VALE, VIV, GCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.