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An Accountant Looks at the Market

What's Next? The Economic Effects of September 11

Alumni Celebration 2001

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Joseph Piotroski, assistant professor of accounting

Value Investing: Nine Financial Performance Signals
Profitability signals
• Positive return on assets
• Positive cash flow from operations
• Increasing trend in return on assets
• Cash flow from operations exceeds net income before extraordinary items
Leverage, liquidity, and source of funds
• Decrease in leverage (measured as LTD to total assets)
• Increase in liquidity (measured by the current ratio)
• Firm did not issue equity in the preceding year

Operating-based signals
• Improvement in gross margins
• Improvement in total asset turnover


An Accountant Looks at the Market

When he looked at the market, Joseph Piotroski took a C.P.A.’s approach to picking value stocks: analyze a company’s financial statement to see how the firm is likely to perform.

The assistant professor of accounting developed a nine-point scale to find the jewels in the financial rough of undervalued companies. In spring 2001, the study—Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers—drew attention from Smart Money.

“The higher a company ranks on Piotroski’s financial strength scale, the better its stock performs over both one- and two-year periods,” Smart Money reported.

In Value Investing, Piotroski concentrates on high book-to-market firms whose stocks traditionally have low market value despite value in their financial statements. “The key feature about them is that their market value is actually smaller than the amount of net assets they have recorded on their financial statements,” he said.

“These are firms that are traditionally poor performers. As a result, the market doesn’t like them and they tend to be under-followed by analysts and institutional investors.”

Still, Piotroski notes that as a group, these stocks historically have strong returns over a two- to three-year period. What he wondered was whether it was possible to weed out the poor performers and identify the winners in advance.

“Embedded in that mix of companies, you have some that are just stellar. Their performance turns around. People become optimistic about the stock, and it really takes off,” he says. And yet, at the same time, “half of the firms languish; they continue to perform poorly and eventually de-list or enter bankruptcy.”

Research on high book-to-market stocks isn’t new. Eugene Fama, Robert McCormick Distinguished Service Professor of Finance, and Robert Vishny, Eric J. Gleacher Distinguished Service Professor of Finance, were among the first to identify this book-to-market effect in the early and mid-1990s, respectively. Fama’s finance literature has demonstrated that this class of stocks, though the worst performers as a group, always have the best returns. Years later, academics are still debating why this effect exists.

Piotroski wrote, “The evidence suggests that the market does not fully incorporate historical financial information into [stock] prices in a timely manner.” His approach was to see if he could apply a theory that picked the winners.

Practice What You Preach
As an accounting professor, Piotroski teaches Financial Statement Analysis to full-time and evening M.B.A. students. He spent three years as a C.P.A. at Coopers & Lybrand before he left in 1992 to pursue an academic career. While working toward his Ph.D. at the University of Michigan, Piotroski started tracking the performance of 20 value stocks that had been in the bottom fifth of low book value stocks. Looking at the firms’ financial reports, he graded the data to measure profitability, capital structure, and operating efficiency.

It took about a year for Piotroski to gather and analyze the research. What he found was that this type of analysis does indeed have predictive power, making it possible to discern which stocks have standout investment potential and which would be better left behind. And by investing in the top performers alone, Piotroski’s research shows, “the mean return earned by a high book-to-market investor can be increased by at least 7.5 percent annually.”

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