Little-known guru, big returns
My Joseph Piotroski-inspired portfolio returned 56% in 2010. Here's how it works.
By John Reese, Validea.com
Living in a society that is obsessed with celebrity, it's important not to confuse fame with success. While many of the pundits you'll see on television or read on the Internet have attained celebrity status, few have attained the types of track records that merit that status -- or your attention.
Conversely, some of the world's most successful investors -- whose advice does merit your attention -- are men and women you've probably never heard of. Joseph Piotroski is a great example. You won't find Piotroski offering investment tips on TV, or Tweeting his latest stock picks on the Internet. In fact, Piotroski isn't even a professional investor; he's an associate professor of accounting at the Stanford Graduate School of Business.
But while Piotroski isn't a Wall Street hotshot, his contribution to the investment world is quite significant. In 2000, while teaching at the University of Chicago's Graduate School of Business, he authored a paper detailing how an accounting-based method of analyzing stocks could produce excellent long-term returns. According to his backtests, the strategy produced annualized returns of 23% over a two-decade period, more than doubling the S&P 500's return. In 2010, his approach fared even better for me. The Guru Strategy portfolio I base on his writings gained 55.9% for the year, and it's kept it up in 2011, already returning 5.0% (through Thursday).
Piotroski focused on stocks with high book/market ratios, which is essentially the same as looking for stocks with low price/book ratios. While other studies had shown that high book/market firms could outperform the market, Piotroski took things a step further. He found that high book/market stocks' collective outperformance was usually driven by a relatively small number of stocks. Many high book/market firms, he found, were trading on the cheap because they were in financial distress, and investors wisely stayed away from them. But sometimes, they were good, solid companies that were flying under the radar for one reason or another.
Piotroski developed an accounting-based method to separate the strong high book/market firms from those that were rightfully being ignored. His method, and the strategy I base on it, takes the top 20% of stocks in the market according to book/market ratio, and then looks for such qualities as positive returns on assets and cash flows from operations, and improving long-term debt-asset ratios, current ratios, return on assets, gross margin, and asset turnover .
Few firms usually pass all of my Piotroski-based model's strict criteria, and often they are very small stocks, some of which are too illiquid for most investors. But the Piotroski-inspired portfolio has found big winners among stocks that get scores of 90%, 80%, or even 70% from the model, and, right now, a number of stocks fall into that category. Keeping in mind that I always invest in baskets of at least 10 stocks to diversify away the stock-specific risk that comes with using quantitative strategies, let's see what types of stocks my Piotroski model currently likes:
Photronics, Inc. (PLAB): This Connecticut-based small-cap ($365 million) makes photomasks -- high precision photographic quartz plates containing microscopic images of electronic circuits -- that are used in the manufacture of semiconductors and flat panel displays.
Photronics gets a solid 80% score from my Piotroski-based model, thanks in part to its 1.22 book/market ratio. And, in its most recent fiscal year, the firm upped its return on assets from -7.75% to 3.25%, lowered its long-term debt/assets ratio from 17% to 11%, and increased its gross margin from 16% to 22%, all reasons the Piotroski model gives it high marks.
Audiovox Corporation (VOXX): This New York State-based consumer electronics firm owns such well-known brands as RCA and Energizer. It makes a wide variety of mobile electronics and consumer electronics and accessories, ranging from vehicle security and remote start systems to MP3 players and digital camcorders to headphones, speakers, and batteries.
Audiovox is a small stock ($171 million market cap), so it is likely to be more volatile than larger stocks. But the firm has taken in more than $570 million in sales over the past year, and it gets a solid 80% score from my Piotroski-based model. One big reason: Its impressive 2.17 book/market ratio. (Looked at another way, that means its shares are trading for less than half of book value.) The firm also posted a 4.14% return on assets in its most recent fiscal year, a sharp turnaround from -13.88% the prior year, and it kept its long-term debt/assets ratio steady at just 2%. Gross margin also improved to 19%, up from 17% the year before.
M&F Worldwide Corp. (MFW): M&F ($480 million market cap) is the parent of several businesses, including Harland Clarke Corp., which makes checks and check-related products, direct marketing, and contact center services; Harland Financial Solutions, which makes software for financial firms; and Scantron Corporation, which offers testing and assessment systems and data collection and analysis services. And then there's an intriguing fourth member of the group: Mafco Worldwide Corp. -- a world leader in the licorice -- that's right, licorice -- industry.
M&F shares surged early this week after a weekend article in Barron's was bullish on the stock, and then slid downward Friday. Its book/market ratio remains in the top 20% of the market, however, at 1.25. It also has the balance sheet and fundamentals to boot: Its return on assets (3.24%) almost doubled in its most recently reported fiscal year, while its current ratio rose to 1.63 (from 1.18) and its long-term debt/assets ratio fell to 62% (from 64%). Overall, the stock earns a 90% score from this approach.
AXIS Capital Holdings Limited (AXS): Headquartered in Bermuda, AXIS provides specialty insurance and treaty reinsurance across the world through operating subsidiaries and branch networks based in Bermuda, the U.S., Canada, the U.K, Ireland, Switzerland, Australia, and Singapore.
AXIS ($4.5 billion market cap) gets a 70% score from the Piotroski-based model. It has a book/market ratio of 1.22, which is in the market's top 20%, and in the most recently reported fiscal year it increased return on assets (2.65%, up from 2.15% the previous year) and had positive cash flow from operations (about $850 million). Its number of shares has also declined in recent years, which this model considers a good sign -- Piotroski found that an increasing number of shares outstanding might be a sign that a firm couldn't generate enough internal cash to fund its business.
I'm long PLAB and AXS.
John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".
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Do it once a year. This allows the best-performing asset classes to take off and run.
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