What are we looking for?
At this time of year, we like to think of the less fortunate – in this case, Canadian stocks that are languishing in the bargain bin, but have decent fundamentals.
Joseph Piotroski, a professor at Stanford University, has discovered that applying a battery of accounting tests to a portfolio of value stocks can improve returns by eliminating ones that are financially too weak to recover and spotlighting ones with improving fundamentals.
In keeping with Prof. Piotroski's strategy, we turned to our Bloomberg terminal to look for stocks in the lowest 20 per cent of the S&P/TSX Composite Index based on their share-price-to-book values. These are usually stocks trading in deep value territory.
We then assessed each stock on the Piotroski scorecard, giving it a single point for any of nine simple tests it passed:
- Return on assets: Pass if the return on assets has increased from prior year.
- Net income: Pass if net income (NI) is more than zero.
- Cash flow from operations: Pass if cash flow from operations (CFO) is more than zero.
- CFO to NI: Pass if CFO is greater than NI.
- Debt: Pass if debt-to-assets ratio decreased over the past year.
- Current ratio: Pass if the company’s current ratio – its ratio of current assets to current liabilities – has increased over the past year.
- Asset turnover: Pass if asset turnover for the most recent year is greater than asset turnover for the previous year.
- Shares outstanding: Pass if the number of shares outstanding is no larger than the year-ago figure.
- Change in gross margins: Pass if the gross margin has increased over prior year.
What we found
Only 10 stocks in the S&P/TSX Composite have Piotroski scores of five or higher.
Prof. Piotroski found that a pattern of buying U.S. value stocks with high Piotroski scores while simultaneously shorting those with low scores would have produced annual returns of 23 per cent between 1976 and 1996.
If history repeats itself, at least some of the stocks listed here will do well because they're cheap in comparison to book value while possessing multiple indicators of financial strength. As always, though, you should do your own research before leaping into any of these names.
The Piostroski scorecard
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