When I first read the results of this academic research study I could hardly believe my eyes.
I had to read it again to grasp its full significance.
I had stumbled onto, what is most likely, the best tool you can use to substantially improve your investment returns.
In a research paper, written in 2000, an unknown accounting professor from the University of Chicago, developed and successfully tested a system where, with the use of a few simple accounting based ratios, so easy to calculate you can do it on the back of an envelope, you can achieve substantial index beating investment performance.
Beating the index may at first not sound that impressive but, if you consider that more than 80% of investment funds worldwide do not even manage that, using this system will easily put your returns in the top 10% of investors worldwide.
Remarkable is that this information still seems to be relatively unheard of amongst investors.
First something on the man behind the study.
The developer of the system is Joseph D. Piotroski is relatively unknown accounting professor who shuns publicity and rarely gives interviews.
He graduated from the University of Illinois with a B.S. in accounting in 1989, received an M.B.A. from Indiana University in 1994. Five years later, in 1999, after earning a Ph.D. in accounting from the University of Michigan, he became an associate professor of accounting at the University of Chicago.
In 2000, he wrote a research paper called “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” (pdf).
He wanted to see if he can develop a system (using a simple nine-point scoring system) that can increase the returns of a strategy of investing in low price to book (referred to in the paper as high book to market) value companies.
What he found was something that exceeded his most optimistic expectations.
Buying only those companies that scored highest (8 or 9) on his nine-point scale, or F-Score as he called it, over the 20 year period from 1976 to 1996 led to an average out-performance over the market of 13.4%.
This is truly outstanding if you think of 80% of investment funds, mentioned above, not even beating the index.
Even more impressive were the results of a strategy of investing in the highest F-Score companies (8 or 9) and shorting companies with the lowest F-Score (0 or 1).
Over the same period from 1976 to 1996 (20 years) this strategy led to an average yearly return of 23%, substantially outperforming the average S&P 500 index return of 15.83% over the same period.
This average out-performance of the index of just over 7% may not seem like much but over the 20 year period an investment of 100 in this long short investment strategy would have grown to 6,282 compared to an amount of only 1,860 if you invested in the S&P 500 index.
The difference between these two rates of return over the 20 year period is over 44 times your initial investment!
After getting really excited about the returns I asked myself if this would also work in Europe and in the current market environment. But more on that later.
How is the Piotroski or F-Score calculated?
1. Return on assets (ROA)
Net income before extraordinary items for the year divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative
2. Cash flow return on assets (CFROA)
Net cash flow from operating activities (operating cash flow) divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative
3. Change in return on assets
Compare this year’s return on assets (1) to last year’s return on assets.
Score 1 if it’s higher, 0 if it’s lower
4. Quality of earnings (accrual)
Compare Cash flow return on assets (2) to return on assets (1)
Score 1 if CFROA>ROA, 0 if CFROA<ROA
5. Change in gearing or leverage
Compare this year’s gearing (long-term debt divided by average total assets) to last year’s gearing.
Score 1 if gearing is lower, 0 if it’s higher.
6. Change in working capital (liquidity)
Compare this year’s current ratio (current assets divided by current liabilities) to last year’s current ratio.
Score 1 if this year’s current ratio is higher, 0 if it’s lower
7. Change in shares in issue
Compare the number of shares in issue this year, to the number in issue last year.
Score 1 if there is the same number of shares in issue this year, or fewer. Score 0 if there are more shares in issue.
8. Change in gross margin
Compare this year’s gross margin (gross profit divided by sales) to last year’s.
Score 1 if this year’s gross margin is higher, 0 if it’s lower
9. Change in asset turnover
Compare this year’s asset turnover (total sales divided by total assets at the beginning of the year) to last year’s asset turnover ratio.
Score 1 if this year’s asset turnover ratio is higher, 0 if it’s lower
Piotroski or F-Score = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9
Good or high score = 8 or 9
Bad or low score = 0 or 1
Back to the question if study works in Europe and in the markets of today.
The answer is a clear yes. And was convincingly answered by my friends Philip Vanstraceele and Luc Allaeys.
In their May 2010 research paper titled Studying different Systematic Value Investing Strategies on the
Eurozone stock market.
They did their comprehensive study of the returns of a few selected value investment strategies applied to European companies over the last 10 years.
What they also did, here is the important part, is they took these investment strategies and looked if they can be further enhanced by applying the Piotroski F-Score.
What they found was astounding.
When they applied the Piotroski F-Score to the following investment strategies:
Joel Greenblatt’s Magic Formula
In each case buying only the top F-Score companies led to a substantial improvement in the results of each strategy compared to buying the low F-Score companies.
For example using the Magic Screen of Joe Greenblatt on companies in Europe resulted in a 10 year average return of 12.71%. Applying the Piotroski F-Score to the same results lead to companies with a highest F-Score (8 or 9) outperforming the ones with the lowest F-Score (0 or 1) by 15.1% on average over the same 10 year period.
In each case buying only the high F-Score companies substantially increased the performance of each investment strategy.
This means that ALL the, already proven, investment strategies were enhanced by using the Piotroski F-Score scoring system.
What is astounding is that, in spite of the substantial benefits the F-Score can add, it has not been taken up more widely by investors and asset management profession.
I have been using the F-Score successfully in my portfolio, and that of my subscribers, for quite some time.
Give the F-Score a try, if the evidence above is anything to go by, it may help you to substantially increase your investment returns, irrespective of what investment strategy you may be following.
Another important point I have not mentioned.
Investing in companies with a high F-Score substantially increases the number of companies with positive investment returns.
The Piotroski study found that over the 20-year period 50% of companies with a high F-Score, held for a year, had positive return whereas if you used a strategy of just buying low price to book companies only 43.7% of the companies you invested would have given you a positive return.
Your Piotroski analyst