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Accounting (Getty Images/iStockphoto)
Accounting (Getty Images/iStockphoto)

equities

A 10-stock portfolio to beat the market Add to ...

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea, a premium Canadian stock screen service. Try it.

If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.” – Billionaire hedge fund manager George Soros

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Which companies have the flashiest products? Which hedge fund managers have amassed the greatest fortune and the biggest homes? Which stocks have the most explosive earnings growth? Most investors thirst for juicy, exciting storylines like these, and the media are only too glad to accommodate them.

But George Soros is right: In stock investing, the road to success is usually not paved in gold, but instead in good ol’ boring concrete.

There may be no better example of that than Joseph Piotroski, who showed that investors can handily beat the market by using the tools of a profession whose dullness often makes it the butt of jokes: Accounting.

In 2000, while an accounting professor at the University of Chicago Booth School of Business, Mr. Piotroski authored a paper entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” The paper focused on stocks with high book/market ratios (the inverse of the price/book ratio), which was not in and of itself groundbreaking.

But Mr. Piotroski used his accounting background to go an important step further. He realized that some high book/market stocks might be inexpensive for good reason: They were in financial distress. So he ran high book/market stocks (those in the market’s top 20 per cent) through a variety of accounting-type tests to make sure they were on solid financial footing.

His findings were big news in the investment world. Mr. Piotroski showed that from 1976 through 1996, a portfolio that was long high book/market stocks that passed his tests, and short those that didn’t, would have produced a 23-per-cent annualized return – more than double the S&P 500’s return over that span.

What accounting tests did Mr. Piotroski use? He wanted a firm’s return on assets and cash flow from operations to be positive, and its cash from operations to be greater than net profits (thus avoiding firms whose profits were due to one-time windfalls). He also wanted to see improvement in several areas, looking for stocks whose long-term debt/assets ratio, current ratio, gross margin, and asset turnover rate in the most recent year were all equal to or better than they were in the previous year. Finally, he wanted the number of shares outstanding to be flat or declining. The logic: New share offerings could be a sign a company can’t generate enough cash internally to run its business.

Mr. Piotroski found that generally, the better a high book/market stock fared on his financial tests – that is, the less risky it was – the better the company did financially in the future and the better its shares performed. That went against traditional notions of risk and reward, which held that to produce higher returns you have to take on more risk. Mr. Piotroski theorized this was because investors were slow to warm to these stronger, improving companies, particularly when they weren’t very well known.

“The evidence is consistent with a market that slowly reacts to the good news imbedded within a high [book/market] firm’s financial statements,” he said in his paper, adding that “the ‘sluggishness’ appears to be concentrated in low-volume, small, and thinly followed firms.” As these firms continued to perform well, however, investors eventually recognized their shares’ value and their stocks jumped.

Because of that, you might think that the Piotroski approach would lose effectiveness in the Internet age, where information is instantaneously available for even the smallest of stocks. But the Piotroski-inspired “Guru Strategy” I developed has worked well since I started tracking it in early 2004.

A 10-stock portfolio picked with the model (which uses the same criteria Mr. Piotroski laid out in his paper) has averaged annualized returns of 5.2 per cent in that time – not bad considering the S&P 500 has averaged just 2.9 per cent annually over the same period.

Because the strategy tends to focus on smaller, unloved stocks, it can be quite volatile from year to year, making it one that should be followed for at least a few years. But it can uncover some great hidden gems – I wrote about the strategy a little over two years ago and since then, one of the two picks I offered, Smart Balance Inc., is up more than 200 per cent. (The other, CRA International, is about flat.)

This year, a 10-stock Piotroski-inspired portfolio has been the best performer of my Canadian portfolios, gaining more than 18 per cent (through Sept. 19) vs. just 4 per cent for the S&P/TSX composite index.

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Validea Canada’s 10-stock, Piotroski-inspired portfolio:

Sheritt International (S)

Capital Power (CPX)

Brookfield Asset Mgt. (BAM.A)

Savanna Energy Services (SVY)

Capstone Mining (CS)

Legacy Oil + Gas (LEG)

Petrobank Energy and Res. (PBG)

Pengrowth Energy (PGF)

Research In Motion (RIM)

Canaccord Financial (CF)

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Here are a few names in the North American markets that earn rave Piotroski reviews right now:

Renewable Energy Group Inc.: This $237-million-(U.S.)-market-cap Iowa-based biodiesel producer converts natural fats, oils and greases into advanced biofuels. Its book/market ratio (1.39) is in the market’s top 20 per cent and its balance sheet also looks good: In the most recent year, its return on assets rate jumped to 4.3 per cent from –15.9 per cent; its current ratio increased to 2.5 from 0.94; its gross margin rose to 15 per cent from 10 per cent; and its long-term debt/assets ratio declined to 31 per cent from 39 per cent.

Petrominerales Ltd.: Based in Calgary, Petrominerales ($715-million market cap) has oil exploration and production in Peru and Colombia. The firm’s book/market ratio is 1.49, which is in the top 20 per cent of the Canadian market. Its return on assets was nearly 35 per cent in the most recent year, up from 20.8 per cent a year before; its long-term debt/assets ratio was 20 per cent, down from 24 per cent; and its current ratio was 1.19, a nice turnaround from –1.69 the previous year.

Fresh Del Monte Produce Inc.: This Kentucky-based fruit and vegetable producer ($1.5-billion (U.S.) market cap) sells its products on five continents around the globe. Its book/market ratio of 1.23 has been hovering around levels at which my Piotroski model would have interest. Its balance sheet, meanwhile, looks very Piotroski-esque. Its return on assets was 3.61 per cent in the most recent year, up from the previous year’s 2.39 per cent; its long-term debt/assets ratio was 9 per cent, down from 12 per cent; and its asset turnover was 1.43, up from 1.41. (Disclosure: I’m long FDP.)

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