Sorting Out the Winners in the Low Price-to-Book Stock Universe

    by Wayne A. Thorp

    There is a mountain of academic research pointing to the long-term success of value-based stock selection methodologies. Such value strategies typically seek stocks with low prices relative to variables such as earnings, book value, cash flow, or dividends.

    One “flaw” in most of this research, however, is that it often relies on constructing large portfolios to beat the market in order to prevent a few large losers from sabotaging portfolio performance.

    While many individual investors attempt to diversify their portfolios, such large-scale diversification is unrealistic. However, research by Joseph Piotroski—an accounting professor at the University of Chicago Graduate School of Business—suggests that is it possible to establish basic financial criteria to help separate the winners from the losers in a low price-to-book-value stock universe.

    Piotroski Overview

    Piotroski’s research focuses on low price-to-book-value stocks. Price relative to book value was a favorite measure of Benjamin Graham and the followers of his investment approach, which sought companies with share prices below their book value per share figures.

    Book value represents the value of the owners’ equity based upon historical accounting decisions. However, over time, events can occur that can distort the book value of a company. For example, inflation may leave the replacement cost of a firm’s capital goods far above their stated book value. Furthermore, different accounting policies among industries may also come into play when screening for low price-to-book stocks.

    Piotroski first limits his universe to the bottom 20% of stocks according to their price-to-book-value ratios. However, he found that most stocks trading with extremely low price-to-book ratios were either neglected by the market or financially troubled. Analysts rarely follow small, thinly traded companies, instead focusing on stocks with broader interest.

    Furthermore, companies in financial distress may be beaten down below their intrinsic value, as investors wait for strong signs that the company has gotten itself back on track. Poor prior performance often leads to overly pessimistic expectations of future performance. However, this pessimism may translate into above-market performance once companies outperform market expectations in subsequent quarters.

    Piotroski found that either situation can create buying opportunities and created a nine-point test to identify promising low price-to-book-value stocks. He used popular ratios and basic financial elements focusing on company:

    • profitability,
    • capital structure, and
    • operating efficiency.

    A screen based on Joseph Piotroski’s research is built into Stock Investor Pro, AAII’s fundamental stock screening and research database program. The exact parameters of our Piotroski screen appear in the box at the bottom of page 32.

    Screen Performance

    Each month, the Web site provides a listing of the companies passing the Piotroski screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1 illustrates that the Piotroski screen has produced returns that are significantly higher than that of large-cap companies over the study period, which began in January of 1998. Through the end of June 2008, the Piotroski screen has generated a cumulative price-change return of 943.5%, or an annualized gain of 25%.

    Figure 1.
    Performance of
    Piotroski Screen

    By comparison, the S&P 500 has gained a cumulative total of 31.9% over the same time period.

    When considering the performance of this Piotroski screen, however, it is important to note that, recently, very few companies have passed month-to-month. Historically, the Piotroski screen has averaged five passing companies per month. However, since the end of 2005, the screen has averaged less than two companies per month, and only one company passed the screen as of July 11, 2008. With such a small number of passing companies, individual company performance plays a key role in the screening methodology’s overall performance.

    Profile of Passing Companies

    Table 1 highlights some of the characteristics of the lone company—L.S. Starrett Co. (SCX)—passing the Piotroski screen as of July 11, 2008, compared to the typical exchange-listed company in the database as well as those exchanged-listed stocks that also rank in the bottom 20% of all stocks based on price-to-book-value ratio.

    The value orientation of Piotroski’s approach is captured in the current price-earnings ratio (current share price divided by earnings per share for the last 12 months), which is lower than that of the typical exchange-listed firm (11.6 versus 15.9). However, the median for the low price-to-book universe of exchange-listed stocks is even lower at 9.1%.

    Piotroski limits his search to the bottom 20% of the stock universe, and as of July 11, 2008, the 20% cut-off translates into roughly 1,400 stocks, with a maximum price-to-book-value ratio of 0.77. L.S. Starrett has a price-to-book value of 0.76 compared to 1.51 for the typical exchange-listed stock. However, the median for exchange-listed low-price-to-book-ratio stocks was even lower at 0.57.

    Table 1. Piotroski Screen Portfolio Characteristics
    Portfolio Characters (Median) Joseph
    Price-earnings ratio (X) 11.6 9.1 15.9
    Price-to-book-value ratio (X) 0.76 0.57 1.51
    Price-earnings-to-EPS est growth (X) na 0.9 1.1
    EPS 5-yr. historical growth rate (%) 79.6 –0.8 14.8
    EPS 3-5 yr. estimated growth rate (%) na 11 14
    Market cap. ($ million) 144.8 79.2 350.9
    Relative strength vs. S&P (S&P=0) (%) 53 –51 –11
    Monthly Observations
    Average no. of passing stocks 5   
    Highest no. of passing stocks 18   
    Lowest no. of passing stocks 0   
    Monthly turnover (%) 28.3   
    Date as of July 11, 2008.

    As we touched on earlier, Piotroski’s analysis often uncovered small, thinly traded companies. This is apparent when looking at the market cap of L.S. Starrett—$144.8 million—and the median market capitalization for low price-to-book-value stocks, which is $79.2 million. By comparison, the typical exchange-listed stock has a market cap of more than $350 million. Looking at the performance of these three groups, you find major differences. L.S. Starrett has outperformed the S&P 500 index by 53% over the last 52 weeks, while the low price-to-book universe has had median underperformance of 51% and the typical exchange-listed stock has underperformed the S&P 500 by 11% over the same period.

    In order to pass our Piotroski screen, a company has to satisfy all nine of his financial requirements. Lowering the financial score to eight would have led to a total of seven companies (L.S. Starrett plus six other firms) passing. Overall, Piotroski found that the higher the financial score, the higher the average portfolio return.

    The six companies satisfying eight of Piotroski’s nine financial tests are included in Table 2. For this group, the most difficult test was maintaining or lowering the number of shares outstanding over the last fiscal year. Smaller companies have more difficulty accessing the credit markets so their sole source of funding may be through issuing new shares. Aviza Technology (AVZA), which designs and markets equipment used in the manufacturing of semiconductors, saw its average number of shares outstanding jump by almost 68% over the last year. Only The Stephan Co. (TSC), a marketer of personal care products, kept its number of shares outstanding constant over its last fiscal year.

    However, the Stephan Co. was the only company of these six that failed to improve its asset turnover (sales divided by average total assets) over the last year. Instead, it remained the same at 0.8.



    Piotroski’s work consists of identifying low-price-to-book stocks and further segmenting them in varying portfolios of financial strength. Overall, however, the higher the financial score, the greater the average portfolio return. Results of individual stocks will vary dramatically. This is especially important to keep in mind for an approach that—at least recently—does not generate many passing companies.

    Even with Piotroski’s additional tests, the results of this screen should not be viewed as a buy list. Instead, it is up to the end-user to perform additional analysis on the passing companies in order to decide whether any match their investing tolerance and constraints.

       What It Takes: Piotroski Price-to-Book Screen
    • The price-to-book ratio ranks in the lowest 20% of the entire stock universe
    • The stock does not trade on the over-the-counter (OTC) exchange
    • The return on assets for the last fiscal year is positive
    • Cash from operations for the last fiscal year is positive
    • The return-on-assets ratio for the last fiscal year is greater than the return-on-assets ratio for the fiscal year two years ago
    • Cash from operations for the last fiscal year is greater than income after taxes for the last fiscal year
    • The long-term debt-to-assets ratio for the last fiscal year is less than the long-term debt-to-assets ratio for the fiscal year two years ago
    • The current ratio for the last fiscal year is greater than the current ratio for the fiscal year two years ago
    • The average shares outstanding for the last fiscal year is less than or equal to the average number of shares outstanding for the fiscal year two years ago
    • The gross margin for the last fiscal year is greater than the gross margin for the fiscal year two years ago
    • The asset turnover for the last fiscal year is greater than the asset turnover for the fiscal year two years ago

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