Stock market gurus come in all shapes and sizes. Some live extravagantly — Martin Zweig once bought the most expensive apartment in New York City, and had a penchant for buying rare – and pricey – pop culture memorabilia. Others are far more unassuming — Warren Buffett still lives in the same Nebraska home he purchased some 50 years ago, before he became known to the world as the “Oracle of Omaha.” Some — like Buffett or Bill Gross — are highly visible and frequently covered by the media; others — like John Neff or Thyra Zerhusen — largely avoid the limelight.
Perhaps most interesting, though, is that one of history’s greatest investment strategists isn’t even a professional investor.
Back in 2000, while a young accounting professor at the University of Chicago Booth School of Business, Joseph Piotroski wrote a paper on stock selection that would reverberate throughout the investment world. In the paper (entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”), he used his accounting background to develop a method for finding unloved stocks with big potential, a method that would have more than doubled the S&P 500’s return from 1976-1996.
Piotroski’s paper impressed me so much that it became the basis for one of my “Guru Strategies,” each of which is inspired by the approach of a different investing great. A 10-stock annually rebalanced portfolio picked with the strategy (one year was the holding period Piotroski used in his study) has returned 7.9% annualized since its early 2004 inception vs. 5.3 for the S&P 500.
Looking for the Overlooked
Piotroski’s approach started with a variable many investors had used before: the book-to-market ratio (the inverse of the price-to-book ratio). He targeted stocks that were in the top 20% of the market based on their book-to-market ratio, meaning that the price investors ascribed to these companies was relatively low compared to the value of their hard assets.
While many investors had simply focused on high book-to-market (or low price-to-book) companies, Piotroski went a key step further, running high book-to-market stocks through a variety of accounting-based balance sheet tests. By doing so, he made sure that investors weren’t ignoring a high book-to-market stock for good reason (i.e., it was a dog, and everyone knew it). My Piotroski-based model makes sure, for example, that a firm’s return-on-assets rate and cash flow from operations are both positive in the most recent year.
Piotroski didn’t just want to see solid fundamentals; he wanted to see improving fundamentals. The model I base on his paper thus looks for a company’s long-term debt-to-assets ratio, current ratio, gross margin, and asset turnover rate to all be equal to, or better, in the most recent year than they were the previous year. In addition, the number of shares a firm has outstanding shouldn’t be increasing (new share offerings may be a sign that the company can’t generate enough cash internally to run its business). And, finally, cash from operations should be greater than net income in the most recent year, to make sure earnings are coming from demand for a firm’s products or services – not because of one-time, unsustainable windfalls.
These criteria are tough to meet, and usually very few stocks will pass all my Piotroski-based tests at any given time. But stocks that get a score of 90% or even 80% from the model can be primed to outperform. Be aware that the Piotroski approach tends to target smaller stocks, which can be volatile (larger stocks with good balance sheets are less likely to fly under the radar and sell at high book-to-market ratios). Because high book-to-market stocks are by definition not getting a lot of love from Wall Street, they’ve often been drawing bad headlines for one reason or another. But given their solid and improving fundamentals, these types of firms could end up being diamonds in the rough for investors. Here are four examples.
Owens Corning (NYSE:OC): Corning is engaged in composite and building materials systems. Its products range from glass fiber used to reinforce composite materials for transportation, electronics, marine, infrastructure, wind-energy and other markets, to insulation and roofing for residential, commercial and industrial applications.
Corning ($3.6 billion market cap) gets a 100% score from the Piotroski-based model and trades at a book/market ratio of 1.06. It has a return on assets of 2.64%, up from -0.25% a year ago, a long-term debt/assets ratio of 26%, down from 27%, and gross margins of 19%, up from 17%.
Ternium SA (NYSE:TX): This Latin American steel producer makes a broad range of value-added steel products, including hot-dipped galvanized and electro-galvanized sheets, pre-painted sheets, tinplate, steel pipes and tubular products, hot-rolled coils and sheets, cold-rolled products, bars and wire rods as well as slit and cut-to-length offerings through its service centers. Ternium ($4 billion market cap) also gets a 100% score from the Piotroski-based model. It trades at a book/market ratio of 1.37 and has a return on assets of 4.39%, up from 1.28% a year ago. It also has a current ratio of 1.73, up from 1.71, and $1.1 billion in cash from operations vs. $452 million in net income.
Era Group Inc. (NYSE:ERA): Era’s helicopters are used to transport personnel to, from and between offshore installations, drilling rigs and platforms. The $450-million-market cap firm operates in the United States, Latin America and the Caribbean, Europe, Asia, and Canada.
Era ($4 billion market cap) gets a 90% score from the Piotroski-based model. It trades at a book/market ratio of 1.02 and has a return on assets of 1.85%, up from -0.07% a year ago. It also has a current ratio of 3.49, up from 3.26, and a 29% long-term debt/assets ratio, down from 30%.
Gulfmark Offshore, Inc. (NYSE:GLF): Another beaten-down oil services firm, Gulfmark provides offshore marine services primarily to companies involved in the offshore exploration and production of oil and natural gas. It operates in the North Sea, Southeast Asia, and the Americas. Its vessels transport materials, supplies and personnel to offshore facilities, as well as move and position drilling structures
Gulfmark ($750 million market cap) gets a 90% score from the Piotroski-based model. It trades at a book/market ratio of 1.43 and has a return on assets of 4.05%, up from 1.13% a year ago. It also has a 28% long-term debt/assets ratio, down from 29%, and an asset turnover rate of 26%, up from 22%.
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