The godfather of value investing, Benjamin Graham, always stated that value investing was fraught with risks, even when using his very strict criteria. Graham realized that with value investing there will always be losses, so the best way to remove much of this risk is for investors to use a well-diversified portfolio of 30 or more stocks that met his strict investing criteria.
Many value investors have sought to construct a method of removing some of the risks associated with value investing, and in my opinion one of the best methods by far comes from, University of Chicago Accounting Professor Joseph Piotroski.
Joseph Piotroski believed that it was possible to improve the performance of a value-focused portfolio if the stocks with the weakest finances were removed first. From this initial thought, Piotroski established a set of nine-criteria for scoring a stock based on its financial data. For every criteria that the company met, it received one point–stocks with eight or nine points were the strongest and possibly the best investments.
The criteria are as follows:
1. Net income; one point if net income for the previous year is positive
2. Operating cash flow; one point if operating cash flow is positive for the previous year
3. Return on assets; one point if the company’s ROA’s is greater than the previous year
4. Quality of earnings; one point if operating cash flow exceeds operating income – warns of accounting tricks
5. Long-term debt vs. assets; one point if the company’s debt to asset ratio has fallen from the previous year
6. Current Ratio; one point if the company’s current ratio has improved from the previous year
7. Shares outstanding; one point if the number of shares in issue is the same as the year before
8. Gross margin; one point if the gross margin exceeds that of the previous year
9. Asset Turnover; one point if the percentage increase in sales exceeds the percentage increase in total assets
So with these strict criteria in place, are there any stocks out there worth buying?
Genworth Financial Inc (NYSE:GNW)
| Metric | 2011 | 2012 | Score |
|---|---|---|---|
| 1.Net Income | $325M | 1 | |
| 2.Operating Cash Flow | $962M | 1 | |
| 3.Return on Assets | 1% | 2.7% | 1 |
| 5.Long-term debt Vs. assets | 7% | 6% | 1 |
| 6.Current Ratio | – | – | 1 |
| 7.Shares outstanding | 493.5 | 494.4 | 1 |
| 8.Gross Margin(Net in this case) | 3% | 7% | 1 |
First up is mortgage insurer Genworth Financial Inc (NYSE:GNW). Genworth’s income and cash flow are both positive, scoring the company two points. Genworth achieved a higher return on its assets in 2011 than it did in 2012 and its ratio of long-term debt to assets also declined, scoring anther two points. Genworth Financial Inc (NYSE:GNW) has almost no current liabilities, so by default, the company scores 1. Shares outstanding have not fallen or risen by a significant amount and Genworth Financial Inc (NYSE:GNW)’s gross margin has expanded from 3% to 7%.
| Metric | Operating income | Operating cash flow | Score |
|---|---|---|---|
| 4.Quality of Earnings | 606 | 962 | 1 |
The quality of Genworth’s earnings scores the company one point as operating cash flow exceeds operating income.
| Metric | Sales Growth | Asset Growth | Score |
|---|---|---|---|
| 9.Asset Turnover | -2.8% | -0.85% | 0 |
However, Genworth Financial Inc (NYSE:GNW) fails the last test, as the company’s sales during 2012 fell faster than the value of its assets.
Total Score: 8
Overall, Genworth Financial Inc (NYSE:GNW) scores 8, one point away from the maximum of 9, indicating that the company is a financially sound value investment.
CenturyLink, Inc. (NYSE:CTL)
| Metric | 2011 | 2012 | Score |
|---|---|---|---|
| 1.Net Income | $776M | 1 | |
| 2.Operating Cash Flow | $6,070M | 1 | |
| 3.Return on Assets | 0.9% | 1.3% | 1 |
| 5.Long-term debt Vs. assets | 38% | 36% | 1 |
| 6.Current Ratio | 0.7 | 0.8 | 1 |
| 7.Shares outstanding | 534 | 622 | 0 |
| 8.Gross Margin | 41% | 33% | 0 |
Next up is beaten down telecoms company CenturyLink, Inc. (NYSE:CTL). CentruryLink had a positive cash flow and net income during 2012 and achieved a strong return on assets in 2011 that in 2012, all of which scores the company 3 points.
Year-over-year CenturyLink, Inc. (NYSE:CTL)’s ratio of long term debt to assets has improved and so has the company’s current ratio – scoring a further two points and taking the company’s total score to 5 out of a possible 9.
However, CenturyLink, Inc. (NYSE:CTL) does not score any points on the next two criteria. CenturyLink, Inc. (NYSE:CTL)’s shares outstanding grew nearly 20% over the year and the company’s gross margin declined from 41% to 33%.
| Metric | Operating income | Operating cash flow | Score |
|---|---|---|---|
| 4.Quality of Earnings | $776M | $6,070M | 1 |
Having said that the company’s operating cash flow exceeds operating income, scoring it a point on the quality of its earnings.
| Metric | Sales Growth | Asset Growth | Score |
|---|---|---|---|
| 9.Asset Turnover | 19.4% | -3.6% | 1 |
Furthermore, sales grew faster than the value of the company’s assets during 2011-2012 allowing the company to easily pass the asset turnover test.
Total Score: 7
Overall, CenturyLink, Inc. (NYSE:CTL) scores 7, two points away from the maximum of 9, indicating that the company is a financially sound value investment.
Rowan Companies PLC (NYSE:RDC)
| Metric | 2011 | 2012 | Score |
|---|---|---|---|
| 1.Net Income | $203M | 1 | |
| 2.Operating Cash Flow | $393M | 1 | |
| 3.Return on Assets | 2% | 3% | 1 |
| 5.Long-term debt Vs. assets | 16% | 25% | 0 |
| 6.Current Ratio | 8.6 | 15 | 1 |
| 7.Shares outstanding | 126M | 124M | 1 |
| 8.Gross Margin | 26% | 28% | 1 |
Rowan Companies PLC (NYSE:RDC) is last in this trio and the company scores well in the first three criteria. That said, the company’s debt has risen year-over-year meaning that it fails criteria number five. However, Rowan Companies PLC (NYSE:RDC)’s current ratio has nearly doubled and the number of shares outstanding has remained constant winning the company another two points. Finally, the company’s gross margin has expanded 2%.
| Metric | Operating income | Operating cash flow | Score |
|---|---|---|---|
| 4.Quality of Earnings | $203M | $393M | 1 |
Rowan Companies PLC (NYSE:RDC)’s operating cash flow is double its net income, earning a point for the quality of its earnings. Meanwhile, sales have grown 48% during the past year, while assets have grown 16%, winning the company another point for asset turnover.
| Metric | Sales Growth | Asset Growth | Score |
|---|---|---|---|
| 9. Asset Turnover | 48% | 16% | 1 |
Total Score: 8
Overall, Rowan Companies PLC (NYSE:RDC) scores 8, one point away from the maximum of 9, indicating that the company is a financially sound value investment.
Conclusion
Overall, value investing can be fraught with risks but using these strict criteria set out by Joseph Piotroski some of the more speculative investments can be ruled out leaving investors with a basket of financially sound companies that could provide some decent returns like those listed above.
The article Piotroski’s Picks originally appeared on Fool.com and is written by Rupert Hargreaves.
Fool contributor Rupert Hargreaves owns shares of Genworth Financial. The Motley Fool has no position in any of the stocks mentioned. Rupert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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