Blog - Investing Notes

October 13, 2004 – Piotroski's Efficient Value Investing

In his January 2002 paper entitled "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers", Joseph Piotroski applies a simple accounting-based fundamental analysis strategy to a broad portfolio of high (top 20%) book-to-market firms to enhance returns. Using data from the period 1976-1996, he finds that:

• Screening on accounting fundamentals boosts the average return earned by a high book-to-market investor by at least 7.5% annually.
• Extending this strategy to buy expected winners and short expected losers would have generated a 23% annual return between 1976 and 1996.
• The benefits of financial statement analysis are concentrated in small and medium-sized firms, companies with low trading volume and firms with no analyst following. Results suggest that the market is slow to react to historical financial information for such companies.
• One sixth of the difference in annual returns between strong and weak firms occurs during the four three-day periods around quarterly earnings announcements.

The author differentiates high book-to-market companies using signals based on nine financial parameters:

• ROA - net income before extraordinary items scaled by beginning of the year total assets
• CFO - cash flow from operations scaled by beginning of the year total assets
• Change in ROA - current year’s ROA less the prior year’s ROA
• Accrual – ROA-CFO
• Change in leverage - historical change in the ratio of total long-term debt to average total assets
• Change in liquidity - historical change in the firm’s current ratio (ratio of current assets to current liabilities at fiscal year-end) between the current and prior year
• Equity offering - whether the firm issued common equity in the preceding year
• Change in margin - current gross margin ratio (gross margin scaled by total sales) less the prior year’s gross margin ratio
• Change in turns - current year asset turnover ratio (total sales scaled by beginning of the year total assets) less the prior year’s asset turnover ratio

Each of the nine signals yields either a good (1) or bad (0) indication. The total score for a company in a given year therefore ranges from 0 to 9. About 10% of the 14,000+ company observations earned a total score of 8 or 9; about 3% earned a score of 0 or 1.

In summary, careful screening of value stocks using accounting fundamentals can significantly enhance returns.

For related research, see Blog Synthesis: The Value Premium.