It's easy to think of great investment strategists and imagine a group of slick, smooth-talking businessmen, clad in expensive suits, and possessing wallets stuffed with wads of cash.
If you've read my past columns, however, you know that great investing minds come in all sorts of packages. Some are indeed high-powered CEOs of investment firms, but others are unassuming, little-known fund managers. And, perhaps most interestingly, some such as Joseph Piotroski -- don't even count stock investing as their day job.
If you haven't heard of Piotroski, you're not alone. A college accounting professor, he was unknown in the mainstream, and generally remains so, but he published a highly regarded academic paper six years ago on stock investing. In the paper, Piotroski focused on stocks with high book/market ratios; that is, stocks of companies whose book values -- which essentially are the net values of their assets -- were high in relation to their stock values.
Focusing on stocks with high book/market ratios wasn't a new idea. Other investors had had success by keying in on such stocks. But Piotroski's research went a step further. By applying a series of fundamental and financial tests to stocks, he was able to separate high book/market stocks that were being unfairly overlooked by investors from those that were being ignored because they were simply bad companies. Using this method, he found that buying strong high book/market stocks and shorting weak book/market stocks would have produced average annual returns of 23 percent -- more than double the market average -- over a 20-year period.
In the more than four-and-a-half years since I started tracking it, the computer model I base on Piotroski's writings has done even better relative to the broader market. It has averaged annual returns of 8.7 percent, while the S&P 500 has returned just 0.9 percent per year.
Given the state of the American stock market right now -- and the complex, esoteric derivative securities that have led to the bulk of its troubles -- I thought it would be a good time to turn to my Piotroski-based strategy, which gets down to some basic, time-tested, accounting-based means of assessing companies (book values, debt/equity ratios, profit margins, and cash flows are a few examples). It's one of my more selective models, but it is high on a handful of stocks right now. Let's take a look at them.
China Southern Airlines Limited (ZNH): Red-hot Chinese stocks ran into a wall last fall, but my Piotroski-based model thinks this airline has taken far more of a hit than it deserves, making it a bargain right now. The Guangzhou-based firm is China's largest airline, with 43 offices located in major metropolitan markets around the world, including Amsterdam, Los Angeles, Paris, Singapore, Seoul, Sydney and Tokyo.
The company, which also offers air cargo and mail services, has taken in more than $8.2 billion in sales in the past 12 months. It has a market cap of $1.41 billion. The first step in Piotroski's method was to determine whether a stock was indeed a high book/market firm. In his research, Piotroski considered such firms to be those whose B/M ratios were in the market's top 20 percent, so that's the standard I use in my model. (Currently, a stock has to have a B/M ratio of about 1.18 to meet that standard.) China Southern's book/market ratio of 1.35 does indeed fall into the top 20 percent of the market, making it the kind of unloved stock Piotroski focused on.
To separate strong high book/market firms from those that were simply dogs, Piotroski used a number of fundamental variables. He wanted to see, for example, that a company had a positive return on assets for the most recent fiscal year, as well as a positive cash flow from operations. China Southern's ROA was 0.62 percent in the most recent year, passing the first test, while its cash flow from operations was more than $1 billion, easily passing the second test.
Piotroski didn't just want to see a healthy balance sheet, however; he wanted to see an improving one. Several of his variables thus focused on whether or not a company's financial position was better in the most recent year than it was in the previous year. For example, he wanted to see a debt/equity ratio that was decreasing and a current ratio (the ratio of a firm's current assets to its current liabilities) that was increasing. Again, China Southern appears to be in good shape. Its debt/equity ratio decreased from 30 percent to 27 percent in the most recent year, while its current ratio jumped from 0.17 to 0.21. It looks like the firm is worthy of more consideration from Wall Street.
Nortel Inversora S.A. (NTL): This Argentinean holding company is the majority stockholder of Telecom Argentina. Based in Buenos Aires, the firm has taken in more than $935 million in sales over the past year. It has a market cap just over $2 billion.
At a whopping 10.01, Nortel easily makes it into the top 20 percent of the market in terms of book/market ratio. But, while the firm is getting little love from investors, its financials are solid. The company's cash flow from operations was close to $1 billion last year -- up from $28.24 million the year before -- and its return on assets is a healthy 0.94.
In addition, Nortel's debt/equity ratio, which was 31 percent two years ago, fell to just 19 percent in the most recent fiscal year. At the same time, its current ratio jumped from 0.52 to 0.65, and its gross margin grew from 39 percent to 45 percent.
The company seems to be progressing nicely, despite its bargain price.
R.H. Donnelley Corporation (RHD): This small-cap ($190 million) is one of the leading Yellow Pagesand online local commercial search firms in America. It distributes more than 700 directories (both print and electronic) with a total circulation of about 80 million, and operates in 28 of the US's 50 states. Over the past year, Donnelley -- located in North Carolina on America's southeastern coast -- has taken in about $2.7 billion in sales.
Like Nortel, Donnelley has one of the higher book/market ratios in the market -- 9.57. That's a sign that the firm is pretty unpopular with investors right now. But, again like Nortel, Donnelley appears to merit a closer look. The firm generated almost $700 million in cash flow from operations last year, and its return on assets for the year -- 0.28 percent -- was also positive. What's more, Donnelley's current ratio increased from 0.76 to 0.82 in the most recent year, and its asset turnover jumped from 0.12 to 0.17, a sign that the firm is getting making more sales per dollar of assets that it owns.
Another reason to like Donnelley: The firm's number of shares outstanding dropped to 68.8 million in the most recent year, down from 70.5 million a year earlier. Piotroski looked for stocks whose number of shares outstanding was not increasing, since selling additional shares is a sign that a firm can't raise enough capital internally to meet its needs. That doesn't seem to be the case with Donnelley, and the stock's strong balance sheet indicates that it should indeed be getting more of a look from investors.
One final note about Donnelley is that, as a small-cap, it could be subject to more volatility than larger firms. That's something to consider if you're interested in buying its stock.
O2Micro International Limited (OIIM): O2Micro creates a variety of power management and security components and systems, such as battery chargers, smart cards, light sensors, and LED drivers. Its products are used in the communications, computer, consumer, industrial, and automotive markets. The firm has locations in the Cayman Islands (its headquarters), the US, China, Korea, Japan, Taiwan, and Singapore, and has brought in more than $170 million in sales over the past year. It's another small-cap, with a market cap of $157 million, so the note about the potential for volatility applies here as it did with Donnelley.
O2Micro is considered a high book/market firm using my Piotroski-based model because its B/M ratio is 1.3, falling into the market's top 20 percent. And the company's balance sheet is quite impressive: Last year, its return on assets rate was a very strong 10.85 percent, and it had no long-term debt. Its current ratio -- also strong at 6.05 -- was up from the previous year (4.94), as were its gross margin (which increased from 55 to 57 percent) and asset turnover (which jumped from 0.63 to 0.72). All of that paints the picture of a solid, improving company whose stock is selling on the cheap -- just the type of firm that Piotroski found tended to beat the market over the long haul.
The L.S. Starrett Company (SCX): Starrett makes an array of tools and industrial, professional, and consumer products, including electronic gauges, a variety of saws and saw blades, and measuring tools. Based in Massachusetts in the US's northeast region, the firm has taken in more than $240 million in sales in the past year despite being a small cap ($151 million market cap).
Starrett catches my Piotroski model's eye first and foremost because of its 1.23 book/market ratio, which is within the market's top 20 percent, a sign that the stock is getting the cold shoulder from investors.
The Piotroski approach also sees a lot to like on Starrett's balance sheet. The firm's return on assets is a solid 2.4 percent, and its cash flow from operations was positive (more than $12 million) in the most recent fiscal year. In addition, the company has been showing improvement in two areas on which Piotroski focused: gross margin, which shows how much money a company is making on each product it sells, and asset turnover, which shows how much sales it is making in relation to the amount of assets it owns. In the most recent year, Starrett improved in both areas, with its gross margin climbing to 30 percent from 23 percent a year earlier, and its asset turnover growing from 0.88 to 0.95 in that same timeframe.
Playing the percentages
In the end, good investing isn't about being a super-genius or about being able to know exactly what will happen before it does -- just think about all the highly intelligent people involved in the recent financial crisis on Wall Street. Instead, it's about understanding lessons that the market has taught us over the years, and finding ways to use those lessons to put the percentages of success in your favor.
Looked at that way, it's no wonder that a numbers-crunching accountant like Piotroski was able to develop a breakthrough quantitative strategy for beating the market over the long haul. By following proven approaches like his, you can stack the odds of success in your favor, which should go a long way toward growing your portfolio over the long run.
At the time of publication, John Reese and his clients at Validea Capital were long on China Southern Airlines.
Published by Globes [online], Israel business news - www.globes.co.il - on September 25, 2008