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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 |
