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.
