Today we want to elaborate on value investing and how it has been modified in recent years. You will hear about an ordinary American accounting professor that has found a signal model based on the value investing framework, that has outperformed the market over decades. The most interesting thing is, that with a little work it can easily be applied with our investment tool.

Research matters

We firmly believe that quantitive analysis based on fundamental information puts the investor in the best possible position when it comes to investing in stocks. A famous quote by Peter Lynch sum up our philosophy:

“Investing without research is like playing stud poker and never looking at the cards.”

Way to many individual investors do not make any research before investing. Often investment decisions are based on news in the daily business newspaper or a tip from your neighbour. Guess what. It produces very poor investment results. As an individual investor, you should use an investment tool that allows you to make good and productive research.

The best institutional investors also make quantitive research in a certain framework – could be macroeconomic, small or large cap, growth, asset plays, turnarounds or sector picking etc. One framework has stood the test of time – value investing. This framework was developed by Benjamin Graham and David Dodd in their classic book “Security Analysis” published in 1934.

(Book cover from the 1951 edition)

Value investing has since then undertaken an evolutionary development with Warren Buffett  adding the management/branding/product element in the investment equation. Warren Buffett has also relaxed on the strict requirements to P/E and P/B values put forward by B. Graham. Peter Lynch, a famous American portfolio manager, has also modified the original value approach with the same elements such as W. Buffett but also adding the “local knowledge” which is about investing in brands/products you can see are popular on main street.

More recently in 2000 an extension to the original value investing was published and has firmly produced good results even during the financial crisis. Its approach to investing is very interesting.

Piotroski’s signal model

In 2000 an American accounting professor, Joseph Piotroski, published a scientific paper “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”. The model is built on the old value investing approach that you should invest in those companies with price-to-book values. J. Piotroski took this idea and made a model that should separate the weakest companies among cheap candidates. In many cases a low price-to-book ratio indicates that something is wrong with business. At other times the company has just lost the “vote” of Wall Street.

The model is built on nine financial ratios:

1. Positive earnings (profitability)
2. Positive cash flow from operating (good liquidity management/inflow)
3. Increasing earnings (sign of growth)
4. Cash flow from operating larger than earnings (prevent earnings from being a non cash flow driven event)
5. Decreasing long-term debt to assets (Leverage)
6. Increasing current ratio (good liquidity situation)
7. Constant or decreasing outstanding shares (need of external funding to service future obligations)
8. Increasing gross margin (looking for improvement of factor costs)
9. Increasing asset turnover (looking for productivity increases on the asset base)

The company is given a one or zero for each ratio. The strategy is then to find companies with price-to-book ratios plus having passed eight or nine of the tests. The next step is then to find the 20% companies with the lowest price-to-book ratio.

Piotroski’s signal model on the North European countries.

Now we have a modified value investing approach. Let us find the 20% companies with the lowest price-to-book ratio on the North European stock exchanges with our stock screener. Based on our stock screener we could estimate, that constraining the price-to-book ratio to maximum 0,8 gave us the 20% companies with the lowest ratio. To use a good case we will analysis the company with the largest market value and a price-to-book ratio under 0,8. Our case is the german automaker Volkswagen.

Stock screening – UPSIDO.com

Piotroski analysis of Volkswagen

1. Positive earnings in 2009? Yes (1 point)
2. Positive cash flow from operating in 2009? Yes (1 point)
3. Increasing earnings in 2009? No (0 point)
4. Cash flow from operating larger than earnings in 2009? Yes (1 point)
5. Decreasing long-term debt in 2009 vs. 2008? No (0 point)
6. Increasing current ratio? No (0 point)
7. Constant or decreasing outstanding shares? Yes (1 point) – a very little increase in shares due to stock options (so no funding problem)
8. Increasing gross margin? No (0 point)
9. Increasing asset turnover? No (0 point)

As we can see from our analysis Volkswagen only scores four out of nine points. Therefore Volkswagen does not qualify as a value investing despite the fact the company has  ”on the paper” attractive value indicators:

• P/E 5 yr: 10,64
• P/B: 0,78

What does the analysis tells us? All measures on profitability except for increasing earnings were positive. Its long-term leverage has gone up during 2009 and its short-term liquidity strength (current ratio) went down in 2009. Not very good signs in terms of financial strength. However this weakening in financial strength did not lead to an issuing of common shares. In terms of pricing power (changing in gross margin) and productivity (asset turnover) Volkswagen saw declines in both metrics.

How fast could we produce this analysis? Very quick actually. With UPSIDO.com’s stock view information we could measure eight out of nine ratios very quickly. Only the amount of shares we had to find on the company’s homepage.

UPSIDO.com has recently provided a comprehensive credit analysis on companies listed on the Copenhagen Stock Exchange for its partner Økonomisk Ugebrev. The analysis shows that 11 companies have high risk of bankruptcy within the next two years.

The credit analysis is built on the principles on credit analysis put forward by professor Altman. His famous formula Altman Z-score gives companies a credit rating based on its historical accounting data. The formula includes total accumulated earnings, current operating earnings, capital structure and asset utilisation. The rating implies the probability of bankruptcy with the next two years. Values above 8,15 corresponds to an AAA-ratingfromS&P and values between 5,65-8,15 corresponds to investment grade ratings. Values between 1,75-5,65 indicates highly speculative investments due to high credit risk. Values below 1,75 indicates extremely high risk of bankruptcy in the near future unless the company becomes cash flow positive or restructure its balance sheet.

The conclusion in the analysis was mentioned in the media. Business.dk brought the story with pictures of the 11 weak companies. RB-Børsen made a more thorough extract from the analysis. We provided the same analysis last year and one of the weakest companies (Mondo) from last year has filled for bankruptcy. The list with weak companies is dominated by real estate and sport entertainment (football clubs and associated activities). On the list, Parken Sport & Entertainment (the company behind Denmark’s largest football club) has been in huge trouble and was forced to issue additionally common stock to pay down debt.

We recommend you as an individual investor to always check the Z-score on the stocks you own or the ones you consider to invest in. You can easily find the Z-score (credit score) under the ratios menu.

As you can see BP’s (British Petroleum) Z-score is 7.05 which indicates a high credit rating and low investment risk in terms of BP’s overall credit risk.

If we look at some well-known companies from the leading UK index FTSE 100 you would be surprised to see which one that are potentially weak.

FTSE 100 companies with low Z-score:

• Thomas Cook Group (2,24)
• Vodafone Group (2,32) – primarily due to their very poor performance in terms of earnings and operating earnings in 2006 and 2007. The past performance is incorporated into the Z-score.
• British Airways (2,43)

Do yourself a favour and check the Z-score on your stocks and build a strong portfolio consisting of companies with high credit ratings.

Yesterday we saw first-quarter earnings from Alcoa (the largest U.S. aluminium producer) and Intel (the world’s biggest maker of computer chips). The conclusion is mixed signals of the recovery.

Intel

The company showed better than expected earnings and sales compared to same period last year. First-quarter earnings was 43 cents compared to 11 cents a share in the same period last year. This clearly shows signs of increased IT-spending from consumers and businesses.

Alcoa

The showed lower-than-expected first-quarter sales that show the capital goods industry is not recovering as fast as expected. Does an increase in sales of 18 percent not tell the market that the economy is recovering? No, not really. The problem is that aluminium prices gained 57 percent from a year earlier so would have expected higher sales. The problem is that the quantities of aluminium is going down. The recovering needs to be based on increases in quantities not rising prices. We want production to rise otherwise the recovery is only numbers increasing from monetisation and low interest rates – which is not a sustainable recovery.

Conclusion

Both companies show good signs of growth in terms of sales and earnings which is ultimately what drives the market forward. The problem is that Alcoa is not showing increases in sales in terms of quantity which is really what matters. Alcoa is a key supplier to the capital goods industry and therefore a leading indicator of future increases in production. Therefore the two reports from Intel and Alcoa give a mixed signal about the recovery. We will be posting updates on the Nordic companies as they report first-quarter earnings.

I dag markerer et skift i vores kommunikation her på bloggen. I takt med, at vi får flere brugere fra andre lande end Danmark samt vores ambitioner om en mere international service, vil vi fremover skrive blogindlæg på engelsk. Dette sprog rammer flest mulige brugere af UPSIDO.com og er derfor den bedste løsning fremadrettet. Vores service vil dog fortsat være på dansk og engelsk, hvilket betyder, at vores support til danske brugere også vil fortsætte på dansk. Vi forventer fremadrettet, at vi vil oversætte vores service til endnu flere sprog i takt med, at behovet stiger.

Vores fremtidige service vil dermed blive på flere sprog, mens vores forretningsmæssige kommunikation udelukkende vil blive på engelsk for at nå ud til flest mulige personer.

Vi håber, at I har forståelse for vores beslutning og fortsat vil læse bloggen, samt følge nyhedsstrømmen omkring vores service, selvom den fremover bliver på engelsk. Og til alle vores udenlandske brugere, håber vi, at I vil se det som en forbedring af kommunikationen.

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Today marks a shift on our blog in terms of our communication. We are getting more and more users from other countries than Denmark and combined with our ambitions of being an international service, our future contributions on the blog will be in English. This language reach out to most users on UPSIDO.com and is therefore the best solution going forward. Our service will continue in Danish and English which means that our support to Danish users will continue in Danish. We are expecting, going forward, that our service will be translated to more language as the need increases.

Our future service will be in multiple language whereas our business communication solely will be in English to reach out to as many people as possible.

We hope that you understand our decision and will continue reading our blog and also follow the news stream about our service even though it will be in English from now on. To all our foreign users, we hope that you will see this as an improvement of the communication.