It is fairly well documented that value stocks with a low price-to-book ratio generally outperform those with a higher ratio in the market. However, as an individual investor, it is sometimes difficult to actualize this concept in the markets. First, the portfolio of low price-to-book stocks in these studies usually consists of at least more than 30 stocks. Second, some securities in that basket of 30 stocks perform miserably while a few gems tend to generate outsized return that pulls the whole portfolio into positive territory.
Let’s say today that you agree with the results of the study and you want to invest your savings of $10,000 in low price-to-book value stocks. However, you realize that there are plenty of such stocks out there and the simulated portfolio in these studies consisted of a diversified list of the lowest 100 price-to-book stocks. Because it would be too expensive to actually buy 100 individual stocks yourself, you decide to pick five stocks out of that list of the bottom 100 in order to represent the portfolio. Chances are, those five stocks will not outperform the simulated portfolio and might not even beat the portfolio of high price-to-book stocks.
This is because there is a reason why some stocks have such a low price-to-book ratio. Most of the time, it is because they are in financial distress – and it would make sense that they are ‘cheap’ and qualify to be a value stock. Of course, some of them will be genuine gems, and as a result they pull up the return of the portfolio eventually. However, this only works if you are conducting an academic study of a large sample of stocks. For an individual investor, randomly picking a few stocks to represent this value thesis can sometimes be a very dangerous proposition. If we take out this randomness, we might stand a better chance.
In this article, I would like to introduce you to a new way to avoid the randomness during your value stock picking. In a paper written by Joseph D. Piotroski of the University of Chicago called Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, the professor formulated an easy way to identify those stocks within the low price-to-book bucket that actually have quality businesses and are not in financial distress.
He calls it the F Score and it is calculated by using a firm’s profitability, financial leverage, liquidity and operating efficiency.
Those companies with a high F Score were found to massively outperform those with a low F Score. Here are the only companies on the Russell 1000 index with the highest F Score possible of 9:
1. Marsh & McLennan Companies, Inc. (MMC, Earnings, Analysts, Financials): Provides advice and solutions in the areas of risk, strategy, and human capital. Market cap at $18.06B, most recent closing price at $33.19.
3. Equifax Inc. (EFX, Earnings, Analysts, Financials): Collects, organizes, and manages various financial, demographic, employment, and marketing information solutions for businesses and consumers. Market cap at $5.88B, most recent closing price at $49.06.
5. Western Refining Inc. (WNR, Earnings, Analysts, Financials): Operates as an independent crude oil refiner and marketer of refined products in Texas, Arizona, New Mexico, Utah, Colorado, and the Mid-Atlantic region. Market cap at $2.19B, most recent closing price at $24.11.
Written by SiHien Goh
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Dig Deeper: Access Company Snapshots, Charts, Filings
- Marsh & McLennan Companies, Inc. (MMC, Chart, Download SEC Filings)
- Tesoro Corporation (TSO, Chart, Download SEC Filings)
- Equifax Inc. (EFX, Chart, Download SEC Filings)
- Office Depot, Inc. (ODP, Chart, Download SEC Filings)
- Western Refining Inc. (WNR, Chart, Download SEC Filings)
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