Piotroski’s F-Score has consistently topped the annualized return charts as one of the best fundamental investment strategies for positive returns. This article is going to break down what the F-Score strategy really measures, how it works, and most importantly, how to use it in a personal investment portfolio. While we can’t guarantee +25% annualized returns from there, we can certainly see how using a screening strategy with such a good track record might provide us with a good starting point for establishing a personal investment portfolio into the future.
The first step to understanding the F-Score system to investing is to understand its background and motivations. Over the last few decades of investment history, value investments have demonstrated their ability to create substantial returns for investors over the long run. While investors like Ben Graham and Warren Buffet take the strategy to its extreme, and created fantastic returns in doing so, other investors ran into issues where they would find themselves buying into what is known as a ‘value trap’. A value trap is a situation where an investor purchases into an investment position that is priced very low against its book value, and therefore appears to present a very strong investment opportunity from a value-perspective.
However, a value trap company will never realize its true potential value, and simply tie up an investor’s money indefinitely. Whether it be a result of illiquidity, non-public information, or simply the market’s overall apathy, value traps continue to plague markets. In order to overcome this barrier, the F-Score adjusts traditional value-investment analysis to then look for growth opportunities as well, by looking at the change in metric values instead of their static worth.
The F-Score system for identifying investments that represent both growth and value-based opportunities involves looking at how it is that nine different metrics in three separate categories indicate the Profitability, Efficiency, and Liquidity of the company in question. Under the profitability category, an investor wants to look for a positive and increasing Return on Assets (this actually functions as two separate metrics), a positive Cash Flow from Operations, and a positive Accrual Ratio, which shows that the company is generally reporting conservative profits.
From there, the efficiency of the company is measures as a function of its improving gross margins and asset turnovers, to show that the company is both increasing its sales and scaling. Lastly, an investor using the F-Score strategy will look for a company that is decreasing its debt ratio, cleaning up its current ratio, and hasn’t recently taken steps to dilute out investors with equity offerings. In combining all of these aspects together, we wind up with a framework for screening financial statements that might represent potential investment opportunities.