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F-score and the treasure hunt for perfect stocks F-score and the treasure hunt for perfect stocks

F-score and the treasure hunt for perfect stocks

The stock market could make you rich. Or it could take everything you have. But if you have a solid strategy you increase your chances that it will be the former alternative. And one strategy that might help you with that is the F-score. A point system that has raked in huge returns in the past.

Background

The F-score system was invented by Chicago accounting professor, Joseph Piotroski. He devised it as a scale, based on financial statements, and it works like a point system. It determines the strength of a business based on a scale from zero to nine. Companies will get a zero if they don’t qualify for any of the criteria. Conversely, they will get a nine if they meet all the criteria.

Good track record

The paper “Value investing: The use of historical financial statement Information to separate Winners from losers”, from 2000, found that the strategy was hugely profitable. Now, the source for this might be a bit biased, since Piotroski himself looked through the numbers. But what he found was that if you had bought high F-score stocks and shorted low F-score stocks, the portfolio would have overachieved. And the return would have been a 23 percent annualized return, between 1976 and 1996.

Works best in Bear markets

A more recent study from Sweden showed that the strategy worked in the Swedish market as well. And another article, on the website Olschoolvalue, compared it to several other value strategies. The article concluded that it was the only strategy that had overachieved, in the latter stages of this recent bull market, that we are currently in now, in 2020.

But the most interesting study was done by the American Association of Individual investors. It compared 63 different stockpicking strategies over one year. And it found that F-score came out on top, with a return of 138 percent, for the year 2010. This could mean that the strategy works even better in bear markets, or when the stock market is just turning from bear to bull market.

Favourite among value investors

Many value investors hold the F-score in high regard, because it is such a rigid system. And not many stocks will score a nine or an eight on the F-score test. Or even a seven. Which means that companies that gets a high score are likely to be more financially robust. Personally, I like the strategy as well. Because it focuses on the current year compared to recent years. Which makes it probable that these stocks are going through a positive change of some sort.

How it works

It is a point system which breaks down stocks into categories. The categories focus on the current year compared to the previous year. The categories are profitability, liquidity, leverage, source of funds and operating efficiency. They are broken down into the following nine criterions, for which one point gets awarded for every criteria that is met:

Profitability criteria:

  • Positive return on assets
  • Higher return on assets for the current year compared to the previous year
  • Positive operating cash flow
  • Cash flows from operations needs to be greater than net income

Leverage, liquidity and source of funds criteria:

  • Decreased leverage: This means having a lower ratio of long term debt for the current year than in the previous year.
  • Higher liquidity/current ratio: The business needs to have more liquidity in the current year than in the previous year.
  • Lack of dilution: No new stocks were issued during the last year.

Operating criteria:

  • Gross margin: It needs to be higher than the previous year.
  • Asset turnover: This needs to be higher than the previous year.

Why these points matter

The reason why these points matter is that profitability is crucial for finding the best stocks. For example, if real cash flows drops it could create cash and payment problems. Even if the earnings and return on assets keeps going up. Which is why the operating cash flow is especially important. Long term debt is bad because the company might own less of its assets then and it might be dependent on its creditors. Therefore cash and assets should be higher than long term debts, percentagewise. Which also gives the company greater opportunity and elbowroom, to reinvest and grow.

Cash generation from dilution is bad. Because it can manipulate the numbers to look better that what they are, and it dilutes the shareholders. Gross margin improvement, on the other hand, is an indication of a responsible management. And it could be a sign of cost improvements, decreases in inventory or the ability to raise prices for products and services. Higher asset turnover could mean that the business is generating higher income on fewer assets. Or that sales are increasing faster than asset purchases.

Quality of earnings

Not many businesses will achieve a nine on the test. And a good score is considered to be six or above. Eight or nine is very good. Conversely, zero to two is very weak. Some of the above criteria goes back to what Warren Buffet describes as the “quality of earnings”. Because since it is quite hard to achieve a high F score, companies that do can often be candidates for investment and trading. One reason being that the quality of earnings is probably high if all those criteria are met. Conversely, companies with a low F-score might be good candidates for short selling.

Taking it with a grain of salt

A high F score does not mean that the stock is undervalued in relation to its price. And it won’t work as well in industries that relies heavily on debt to grow. But then again I stay away from those industries any way. So personally I think the F-score is a good complement to other valuation methods. Although I should probably use it more often. And for someone who don’t have the time to do a lot of stock analysis, the F-score might be a good tool, to help manage a less time consuming and less concentrated portfolio.

Conclusion

Having a high F-score is indicative of a robust business. But looking at past results don’t necessarily tell us anything about the future. Just ask Benjamin Graham, who lived through the 1929 stock market bust and had to change his whole approach after losing a lot of his capital in that crash. The F-score is going to screen for good businesses. But that does not mean that they are undervalued in relation to price. And to find stocks that are both high on F-score and cheap, you need to find out their intrinsic value and margin of safety first.

To screen for high F-score stocks you could use any good screener. For example Morningstar, Zacks or Gurufocus.

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