Today I’m sharing 3 value investing strategies that have consistent success in finding undervalued stocks.
One is a fundamental analysis strategy from the father of value investing himself, Ben Graham. Another is a blend of fundamental analysis with a dash of momentum and trend following thrown in from a founder of an investment firm managing over $6 billion in assets. Lastly, we’ll wrap up with a more modern fundamental analysis strategy developed by an academic in the 1990’s.
- The Graham Value Investment Strategy
- Combining Momentum and Value – The O’Shaughnessy Strategy
- The Piotroski F-Score Value Strategy
- About Joseph D. Piotroski
- Piotroski F-Score criteria
- Which value investing strategy is best for finding undervalued stocks?
The Graham Value Investment Strategy
From Ben Graham, father of value investing, mentor to Warren Buffett and author of the timeless book on value investing: The Intelligent Investor
Benjamin Graham developed his investing strategy during The Great Depression. He referred to it as picking up used, and discarded cigar butts that still had a puff or two left in them. He reasoned that the market was inefficient (it still is) and that many of the companies left for dead still had a little bit of life in them, or a puff or two as it were.
Graham’s strategy formed the foundation of Warren Buffet’s own investment strategy – one that was modernized and improved by his partnering with Charlie Munger. But that’s a different story..
Ben Graham’s strategy, sometimes referred to as the Benjamin Method of Investing, is based on fundamental analysis, as opposed to technical analysis. One of Graham’s most influential insights was that there are two types of people who buy stocks: Investors and speculators. He likened speculators to gamblers who did little more than back the favored horse (or stock, in this case).
Benjamin Graham’s method focused on investors who favored analysis of the company’s fundamentals. Emphasis was placed on the book value of a stock. The thinking was that if the stock was trading at less than the value of the underlying assets then it was undervalued and the investor would be rewarded for purchasing it.
Best case: the stock gains in value and becomes worth more than the underlying assets.
Worst case: the company goes out of business and sells its assets to pay off the investors.
Either way, it’s a win for the investor.
Is Benjamin Graham still relevant?
Benjamin Graham the man is entirely relevant today if for no other reason than the fact that almost every method for valuing a stock stems from his value investing strategy.
His book, The Intelligent Investor, should be in every value investor’s library.
It’s important to note though that very few stocks trade at below their book value per share – even during the financial crisis of 2008.
This is one of the reasons Buffett and Munger adapted Graham’s method – it became less effective in the decades after The Great Depression as the economy recovered.
Today’s version of the Benjamin Graham Method of Investing is Discounted Cash Flow Analysis, or DCF for short.
Still, Graham is responsible for a few foundational concepts that still inform value investors to this day:
- Intelligent investing is objective – i.e. not based on emotion.
- Nobody can see the future, so you must have a Margin of Safety (i.e. buy undervalued stocks that are still likely to pay off even in a worst case scenario).
- By avoiding the “hot stocks” and opting for solid businesses, you can defend against the unknown nature of the future.
- The Stock Market as a whole is moved by irrational, emotional reactions of individual investors. This provides opportunity for the Value Investor.
- Mean reversion is a fundamental law. Bubbles always burst and bull markets end. But more importantly – bear markets also end and stock value mirrors underlying company value over the long run.
Combining Momentum and Value – The O’Shaughnessy Strategy
James O’Shaughnessy’s Trending Value investment strategy is built on a simple concept:
- Pick the most undervalued companies.
- Pick companies with the highest stock price increase over the past six months.
In his book (What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time), James O’Shaughnessy details how combining momentum and value factors significantly increases stock market returns.
The nice thing about this method is the addition of the second bullet- highest stock price increase over the past six months. This shows that the stock is of interest to investors now. No need to sit and wait for Mr. Market to realize the stock has value.
It’s the best of both worlds!
His name for this combined momentum and value investment strategy is “The Trending Value portfolio”.
To implement the Trending Value strategy you must first learn about the Value Composite Two Indicator.
Value Composite Two Indicator.
The Value Composite Two Indicator is a valuation indicator calculated from six stock valuation ratios:
- Price to earnings
- Price to book value
- Price to sales
- EBITDA to EV (Earnings before interest, taxes, depreciation and amortization to Enterprise value)
- Price to cash flow
- Shareholder Yield (Dividend yield + Percentage of Shares Repurchased)
To calculate the Value Composite Two Indicator:
- Compare any given stock to all other stocks on each of the above ratios. The least expensive gets a 1 and the most gets 100.
- Next, combine the six scores for the ratios into one sum.
- Finally, sort the stocks from lowest (most undervalued) to highest (most expensive).
It’s impractical to do this by hand, but there are a number of sites and screeners that do this for you.
It’s also possible to get the Value Composite Two score for a stock and get a feel for its value related to current price. For example, a stock with an indicator of 50 would be fairly valued, one with a 20 would be undervalued and so forth….
The Piotroski F-Score Value Strategy
Piotroski’s F-Score strategy is pretty simple to follow and understand – on the surface. It’s a 9 point checklist of criteria covering the Profitability, Balance Sheet Health and Operating Efficiency of a company.
The Piotroski F-Score is a strategy that seeks to identify companies with strong fundamentals that are likely to outperform the broader market, while simultaneously identifying stocks that are likely to be a value trap.
Companies are ranked on a scale of 0 to 9 using specific criteria.
The companies ranking in the 7-9 are likely to outperform, while those in the 0-3 are most likely to be value traps.
Buying companies that scored 7-9 during the 20 year period 1976 to 1996 outperformed the market by 7.5%. Shorting stocks that ranked 0-1 increased those returns to a stunnning 23% annual return !
About Joseph D. Piotroski
Joseph D. Piotroski has been described as a man who “shuns publicity and rarely gives interviews.”
I like him already.
He has a B.S. in accounting from the University of Illinois, an M.B.A. from Indiana University and a Ph.D. in accounting from the University of Michigan. In 2000, while an associate professor of accounting at the University of Chicago, he published his research paper: “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.”
“I show that the mean return earned by a high book-to-market investor can be increased by at least 7.5% annually through the selection of financially strong high BM firms while the entire distribution of realized returns is shifted to the right. In addition, an investment strategy that buys expected winners and shorts expected losers generates a 23% annual return between 1976 and 1996, and the strategy appears to be robust across time and to controls for alternative investment strategies.”Joseph D. Piotroski
Piotroski F-Score criteria
Determining the F-Score (short for “Financially Sound Score”) of a given company is a simple checklist of the following 9 criteria points:
- Positive return on assets (ROA) in the current year.
- Positive operating cash flow in the current year.
- Higher return on assets in the current period compared to the ROA in the previous year.
- Cash flow from operations are greater than Net Income.
BALANCE SHEET HEALTH SCORES
- Lower Long-Term Debt to Asset Ratio in the current period compared value in the previous year.
- Higher current ratio this year compared to the previous year.
- No new shares were issued in the last year.
OPERATIONAL EFFICIENCY OF THE COMPANY
- A higher gross margin compared to the previous year.
- A higher asset turnover ratio compared to the previous year.
The beauty of this checklist is that the values are available (or derived from values) on all 10-K and 10-Q filings.
Also, the criteria is based on GAAP (Generally Accepted Accounting Principles) values in the filings. Those are the values that people go to jail for lying about, so they are less prone to CEO/CFO game playing.
The company gets 1 point for each criterion it meets, and a 0 if they fail to meet the checkpoint.
Total up the points, and that’s the F-Score.
As mentioned above, companies scoring 8-9 are strong candidates while those scoring 0-2 are best to avoid, or to short (if you’re adventurous).
Piotroski himself is said to apply his F-Score method to the list of results from his “mother filter.” His mother filter was a screen based on low price/book value stocks, but the F-Score could be run on any subset of stocks if your own “mother filter” uses different criteria.
Notes and limitations
- The Piotroski F-Score value stock strategy does not work for banks, insurers andCapEx heavy industries, because debt is required to keep the business running. This would obviously cause a loss of F-Score points on the Balance Sheet analysis.
- Piotroski’s F-Score strategy was one of only a few stock strategies to produce strong positive results during the 2008 financial crisis.
- The F-Score is such a successful strategy in part because so few companies achieve an F-Score of 8-9.
- Return on Assets (ROA). Net Income divided by the Total Assets.
- Operating Cash Flow (OCF). Operating cash flow represents the cash from a company’s net income and is less prone to accounting gimmicks than Net Income is. Here are two common formulas for calculating Operating Cash Flow (courtesy of https://www.investopedia.com/):
- Cash Flow from Operating Activities = Funds from Operations + Changes in Working Capital
- Cash Flow from Operating Activities = Net Income + Depreciation + Adjustments To Net Income + Changes In Accounts Receivables + Changes In Liabilities + Changes In Inventories + Changes In Other Operating Activities
- Increased ROA. This is pretty self-explanatory. You just need to calculate the ROA today and 12 months previous. Compare the two and today should be larger.
- OCF > ROA. Cash Flow is what funds employee wages and benefits, dividends and debt. You want to make sure that there is enough of that, and if Net Income is higher then it might be unsustainable. (A higher Net Income would create a larger ROA, so this step attempts to compensate for that.)
- Long-Term Debt to Asset Ratio. Growing debt will make it harder to grow profitability in a downturn.
- Current Ratio. This is found by dividing Total Assets by Total Liabilities. You want to see a larger/growing number, which means liabilities are manageable and liquidity is increasing.
- New Shares Issued. This item goes to Dilution. Companies love to issue new stock, but it dilutes the earnings and cash flow per share, which is bad for investors. You can think of it as a type of inflation and is best to be avoided.
- Gross Margin. Companies that can grow their margins have moat. They are more likely to have resilience in tough economic climates.
- Asset Turnover. Asset turnover is a measure of efficiency. Here is the formula: Asset Turnover = Total sales(revenue) divided by the average Total assets over the prior year. ([assets at start + assets at end]/2)
Which value investing strategy is best for finding undervalued stocks?
Like most stock market strategies, it depends on a lot of different things. Some stop working when too many people start using it. Other times macroeconomic events changes the market enough that the strategy no longer works. We see this in Graham’s version of Book Value based investing.
Personally, I’ve had good success with a mix of all three of these strategies. Traditional, DCF based value analysis paired with the Piotroski F-Score works well. If the stock passes the O’Shaughnessy Strategy as well, then you’ve hit the Trifecta!*
*Sorry for the racing metaphor… I know it jumbles the gambling/speculation vs. investing message, but I just couldn’t resist.