Outsmarting Value Investors for Years

06/10/2011 8:00 am EST


John Reese

Founder and CEO, Validea.com And Validea Capital Management

A new face to the value-investing ranks has been performing well over the long term with an unconventional approach, notes John Reese of the Validea Hot List.

If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul.

No fancy formulas, no insider knowledge—just a straightforward assessment of a company's balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios—i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Through his research, Piotroski developed a methodology to separate the solid (but overlooked) high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percentage points annually.

In addition, he found that buying the high book/market firms that passed his strategy, and shorting those that didn't, would have produced an impressive 23% average annual return from 1976 to 1996.

Since I started tracking it in late February 2004, a ten-stock portfolio picked using my Piotroski-based model has outperformed the market, though with some big ups and downs.

Diving into the Balance Sheet
Piotroski noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners.

The first step in this approach is, of course, to find high book/market ratio stocks.

That's the easy part. The harder part is determining whether investors are avoiding a high-book/market stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this.

Piotroski also thought that good companies had cash from operations greater than net income. Such companies are making money because of their business—not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski' other financial criteria don't necessarily look for fundamental excellence, but instead for improvement.

Among the other "change" criteria Piotroski examined were:

  • the long-term debt/assets ratio, which he wanted to be steady or declining;

  • the current ratio (current assets/current liabilities), which he wanted to be steady or increasing;

  • gross margin, which should be steady or rising;

  • and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (it should be steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are a few of the stocks currently in its ten-stock portfolio:

  • SkyWest, Inc. (SKYW)

  • Smith Micro Software Inc. (SMSI)

  • Benchmark Electronics, Inc. (BHE)

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