What are we looking for?
Beaten down stocks that have the financial muscle to stage a comeback.
Joseph Piotroski, a professor at Stanford University, has discovered that applying some simple accounting tests to a portfolio of traditional value stocks can result in improved returns by eliminating stocks that are financially too weak to recover.
He devised a nine-point scoring system for evaluating a stock's financial strength. Stocks that score eight or nine on his scale tend to do better than those that score one or two.
We looked for Piotroski stocks on the S&P 500 by restricting our search to those stocks with price-to-book values of 1.25 or less – beaten-down value stocks, in other words. Then we assessed each stock on the Piotroski scorecard:
-Net income: Score 1 if last year's net income was positive.
-Cash flow from operations: Score 1 if last year's cash flow was positive.
-Quality of earnings: Score 1 if last year's operating cash flow exceeds net income.
-Return on assets: Score 1 if last year's ROA exceeds prior year's.
-Long-term debt v. assets: Score 1 if the ratio of long-term debt to assets has decreased from prior year.
-Current ratio: Score 1 if the current ratio has increased from prior year.
-Shares outstanding: Score 1 if the number of shares outstanding is no larger than year-ago figure.
-Gross margins: Score 1 if gross margin has increased over prior year.
-Asset turnover: Score 1 if the percentage increase in sales is greater than the percentage increase in total assets.
What we found
Only 14 stocks scored an 8 or 9 on the Piotroski tally.
Prof. Piotroski found that a pattern of buying value stocks with Piotroski scores of 8 or 9 while simultaneously shorting those with scores of 1 or 2 would have produced annual returns of 23 per cent between 1976 and 1996.
If history repeats itself, at least some of the stocks listed here will do well because they're cheap in comparison to book value while possessing multiple indicators of financial strength.