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Equity markets performed well in 2017, but value investors have struggled to identify new investment ideas. Why is this the case and is there a simple method for screening for quality companies?

Value investing is the method of using fundamental business and accounting analysis to invest in businesses that are perceived to be undervalued. Part of the reason fund managers have struggled to find new investments is that valuation multiples continue to expand, while company profits have grown at a slower rate. In simple terms US, UK and European markets have become approximately 5-10% more expensive between 2015 and 2016 financial year (2017 data yet to be released). From their point of view, this makes it harder to find undervalued stocks.

Piotroski’s F-Score is an investment strategy used to screen for new equity ideas. It is a method developed in 2000 by Boston based accounting professor Joseph Piotroski. It uses a nine point checklist to score a company’s investment qualities, with the best companies scoring 8 or 9 points. The method is split into three categories: profitability, balance sheet strength and operational efficiency. Originally it was used to look at value stocks based on a low share price to book value (Net asset value per share), to find which had the greatest chance of outperforming the market. Critically, the principal focuses on the company financial analysis over the investment case.

The criteria are as follows:

Profitability Criteria

Positive Net Income in the current year (1 point)

Positive return on assets in the current year (1 point)

Positive operating cash flow in the current year (1 point)

Cash flow from operations being greater than net income (quality of earnings) (1 point)

Balance Sheet Criteria

Lower ratio of long term debt in the current period, compared to the previous year (decreased leverage) (1 point)

Higher current ratio (current assets divided current liabilities) this year compared to the previous year (more liquidity) (1 point)

No new shares were issued in the last year (lack of dilution) (1 point)

Operating Efficiency Criteria

A higher gross profit margin compared to the previous year (1 point)

A higher asset turnover ratio (Sales divided by assets) compared to the previous year (1 point)

Conclusion

A disciplined approach to stock selection is very important. Piotroski’s checklist is a very simple way of screening for quality businesses. Although we see better methods for identifying value than price to book, for example, focusing on free cash flow generation, testing of this investment strategy has shown strong performance compared to the S&P 500 over the long term. Below is the current distribution of scores of the FTSE 350.

FTSE 350 Scores