An intelligent extension to value investing
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.
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.
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:
- Positive earnings (profitability)
- Positive cash flow from operating (good liquidity management/inflow)
- Increasing earnings (sign of growth)
- Cash flow from operating larger than earnings (prevent earnings from being a non cash flow driven event)
- Decreasing long-term debt to assets (Leverage)
- Increasing current ratio (good liquidity situation)
- Constant or decreasing outstanding shares (need of external funding to service future obligations)
- Increasing gross margin (looking for improvement of factor costs)
- 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
- Positive earnings in 2009? Yes (1 point)
- Positive cash flow from operating in 2009? Yes (1 point)
- Increasing earnings in 2009? No (0 point)
- Cash flow from operating larger than earnings in 2009? Yes (1 point)
- Decreasing long-term debt in 2009 vs. 2008? No (0 point)
- Increasing current ratio? No (0 point)
- Constant or decreasing outstanding shares? Yes (1 point) – a very little increase in shares due to stock options (so no funding problem)
- Increasing gross margin? No (0 point)
- 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.