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An employee sifts diamonds at a diamond cutting and polishing factory in Surat in the western Indian state of Gujarat. (Arko Datta/Arko Datta/REUTERS)
An employee sifts diamonds at a diamond cutting and polishing factory in Surat in the western Indian state of Gujarat. (Arko Datta/Arko Datta/REUTERS)

Strategy

Scoring with the accountant's view on stocks Add to ...

In the dozen-plus years I've spent researching history's greatest investment minds, one of the things that has struck me is that stock market masters come in all shapes and sizes.

Some, like Martin Zweig, live extravagantly. Mr. Zweig once bought the most expensive apartment in New York City, and has a penchant for buying rare - and pricey - pop culture memorabilia.

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Others, like Warren Buffett, are far more unassuming; Mr. 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."

Perhaps most interesting, though, is that at least one of history's top investment strategists, Joseph Piotroski, isn't even a professional investor.

Back in 2000, while a young accounting professor at the University of Chicago Booth School of Business, Mr. 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.

Mr. 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. And so far in what has been a mediocre year for the market, the Piotroski method has been a stellar performer. A 10-stock portfolio picked using the strategy was up 10.1 per cent through Aug. 12, while the S&P 500 was down 2.8 per cent.

Diamonds in the rough

Mr. 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 per cent 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, Mr. 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.

Mr. 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. Right now, no stock that meets my standards for market capitalization and volume gets a perfect score from the model. The two stocks below come close, though, earning 90 per cent scores. 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.

CRA International

Boston-based CRA (Charles River Associates) provides economic, financial, and business management assistance to businesses and governments around the world. It has been hit hard over the past couple of years by the economic slowdown, but my Piotroski-based model sees a lot to like about it, starting with its strong 1.43 book-to-market ratio. CRA, which currently has a market capitalization of $180-million (U.S.), also has a positive and improving return on assets (1.84 per cent last year vs. 1.75 per cent the previous year); an increasing current ratio (2.91 last year vs. 2.30 the prior year); and a declining long-term debt-to-assets ratio (15 per cent last year, down from 19 per cent).

Smart Balance Inc.

This New Jersey-based food and beverage maker's products include "heart healthier" alternatives to foods that are often high in harmful fats or cholesterol. The $240-million market cap company has a strong 1.89 book-to-market ratio, as well as an improving return on assets rate (0.61 per cent last year, up from negative 1.22 per cent the prior year). It also has a declining long-term debt-to-assets ratio (9 per cent last year versus 12 per cent a year earlier); and rising gross margins (48 per cent last year, up from 43 per cent).

Disclosure: I do not own shares of CRAI or SMBL.

 
Security Price Change
CRAI-Q CRA International 21.331 0.381
1.819 %
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