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How to Find the Best Busted Stocks

The market may be picking up, but even so, growth-stock investors won’t find many promising candidates.

Why? Growth investing is about finding profitable companies with strong recent sales and earnings growth. Stocks meeting those requirements are few and far between these days.

So, even diehard growth investors will have to borrow from the value investor’s toolbox to find worthwhile candidates. Value investors look for beaten down stocks likely to recover when the economy picks up, and that brings Joseph Piotroski to mind.

Piotroski's Breakthrough
Piotroski, an accounting professor at the University of Chicago, devised a nine-step method for finding the best value candidates. The system rates stocks on financial strength and profitability. Piotroski reasoned that value-priced (low price/book ratio) stocks rating high in these categories would be the best performers.

He was right! Piotroski found that value stocks receiving passing grades using his system outperformed a portfolio of all value-priced stocks by an impressive 7.5 percent annually. My own testing using his formula has also shown promising results.

Simple to Apply
Piotroski’s system is easy to use. Each of his nine steps consists of a simple test. You give the stock one point if it passes and zero if it doesn’t. Five points constitutes a passing grade, and higher is better.

Here’s how to implement Piotroski’s scoring system using data from just two sites, Morningstar, and Hoover’s. Everything you need is free. Start on Morningstar (www.morningstar.com) by getting a price quote. 

Start With Morningstar
#1) Positive Net Income: Net income, the bottom line after-tax profits, is the simplest measure of profitability. Companies with positive net income are, by definition, profitable. You can use Morningstar’s Five-Year Financials report lists net income going back five years. Get there by selecting “5-Yr Financials” from the Financials dropdown menu. Add one point if the trailing twelve months (TTM) net income is positive, and zero if not. 

#2) Positive Cash Flow: Cash flow is arguably a better profitability measure than net income. Cash flow measures the money that actually moved into or out of a firm’s bank accounts. By contrast, net income results from a variety of subjective accounting decisions, such as how fast to depreciate assets. Morningstar lists operating cash flow just a few lines below net income on the Five-Year Financials report. Add one point if the trailing twelve months (TTM) operating cash flow is positive.

#3) Earnings Quality: Many experts compare net income to operating cash flow to detect potential accounting shenanigans. Cash flow normally exceeds net income because depreciation and other non-cash expenses reduce income, but not cash flow. The reverse condition, when net income exceeds cash flow, signals possible accounting mischief. Award one point if the TTM operating cash flow exceeds the TTM net income.

#4) Decreasing Debt: Piotroski rewards companies that are reducing their debt levels. He uses “financial leverage,” which is total debt divided by its total assets, to quantify debt. You can find financial leverage on Morningstar by selecting Stock Grades on the Snapshot dropdown menu. Award one point if the most recent annual figure is less than the year-ago value.

#5) Increasing Working Capital: Working capital, the difference between current assets and current liabilities, measures the cash available to run the business. Piotroski prefers stocks with increasing working capital. Current ratio, which is current assets divided by current liabilities, is the usual metric for expressing working capital. Morningstar’s Stock Grades report displays the current ratio going back five years. Award one point if the most recent annual figure exceeds the year-earlier number.

#6) Improving Productivity: Piotroski uses asset turnover, which is revenues divided by total assets, to measure productivity (higher is better). You’ll find it the Profitability section of the Financial Grades report. Award one point if the most recent annual asset turnover exceeds the year-ago figure.

#7) Growing Profitability: In contrast to asset turnover, which gauges how well a firm employs its assets to generate sales, return on assets (ROA) measures overall profitability by comparing net income to total assets (net income divided by total assets). Morningstar lists ROA in the same section as asset turnover. Award one point if the most recent annual ROA exceeds the year-ago figure.

Switch to Hoover’s (www.hoovers.com) to obtain the data for the final two tests.

Switch to Hoover's
#8) Issuing Stock: Piotroski prefers companies that do not need to issue more stock to raise capital or to fund acquisitions. From Hoover’s homepage, enter the company name and then click on Financials. Award one point if the most recent number of total shares outstanding is equal to, or less than, the year-ago figure.

#9) Competitive Position: Increasing competition often forces companies to cut prices, and hence profit margins, to maintain sales. Conversely, rising profit margins may signal an improving competitive position. Piotroski uses gross margin, the profit a firm makes before considering overhead, to gauge the competitive environment. Hoover’s Financials report lists the gross margins. Award one point if the most recent quarter’s gross margin (Gross Profit Margin) exceeds the year ago number.

Piotroski’s scoring system is effective and easy to use. But it doesn’t know if a firm’s CEO has been indicted for fraud, or if a competitor’s new offering has rendered a firm’s major product obsolete. You still have to do your due diligence.
published 8/20/03 & 8/27/03

 

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