It's Lonely at the Top

 | Feb 27, 2012 | 10:30 AM EST
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Last week I started a series of columns that highlight guru strategies I rarely have a chance to write about because they favor so few stocks. That first column discussed David Dreman, and today's focus is Joseph D. Piotroski.

The stock strategies I use are based on the writings of some of Wall Street's most notable investors and theorists. Piotroski is an associate professor of accounting at the Stanford Graduate School of Business, the only full-time academic I include among my guru strategists and the only one who's not a professional investor. He has a Ph.D in accounting from the University of Michigan and an MBA from Indiana University.

Investors pay attention to Piotroski because of a 2000 paper on value investing he wrote that appeared in the Journal of Accounting Research. The research identified an important variable worth looking at: a high book-to-market ratio, the inverse of price-to-book. (His definition of "high" means companies whose ratios are in the top 20% of the market.) My own Piotroski-based strategy has been operating since Feb. 27, 2004, and it has since produced a 5.3% annualized rate of return -- 2.5x the S&P 500's 2.2% in the same period.

Book value means total assets minus total liabilities, and the value the market gives them is their market capitalization. Piotroski found that if the former number is high vs. the latter, buying such stocks can translate into a big investment win, if one eliminates the losers. As for how to achieve that last bit, he provides a series of screens for removing the undesirables -- and, in the end, he's found that buying high book-to-market companies that pass his tests produce outsized returns. The screens are vital, because many companies with high book-to-market ratios are in financial distress and must be avoided.

The screens he uses include profitability, or companies that are able to generate funds internally; financial leverage and liquidity, or an ability to meet future debt-service obligations; and operating efficiency.

Within these general categories are specific tests relating to return on assets, cash flow, a comparison of cash from operations to net income, long-term debt-to-assets, the current ratio, change in shares outstanding, change in gross margin and change in asset turnover. Piotroski has been quoted in an interview as saying, "I think I'm a value investor at heart."

One company highly favored by the Piotroski strategy is Monster Worldwide (MWW), which provides employment services through Internet job boards. The company has a presence in about 50 countries and is well known for its website.

Monster has a book-to-market ratio of 1.45:1, which places it among the top 20% of stocks for this number. It also has a positive return on assets, a positive cash flow from operations, no long-term debt, increasing gross profit margins and increasing asset turnover when compared with the previous fiscal year. In other words, it has a high book-to-market ratio, but also turns in solid financial performance.

Another Piotroski favorite is China Yuchai International (CYD), which manufactures diesel engines in China used in automobiles, as well as engine parts and diesel power generators. The company furthermore has interests in hospitality operations, property development and consumer electronic products distribution.

China Yuchai's book-to-market ratio is 1.35:1, which likewise puts it in the top 20% of stocks. As with Monster, this company passes every stress test the strategy places on it, which suggests the company's financials are strong.

The Piotroski strategy does not recommend many stocks, but those it favors tend to do well. Monster and China Yuchai, therefore, are certainly worth a closer look.


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