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A sure shot method of avoiding value traps?

Jun 12, 2013

It is very common for value investors to get excited when they come across a company trading at a deep discount. Deep discount typically means very low valuations. Especially when compared to a company's intrinsic value. These include lower price to earnings multiples or price to book value, amongst others. Having said that, it is also quite common for value seekers to get stuck in such stocks - also termed as 'value traps'. Value traps essentially are stocks that trade at very low valuations and continue to do so for long periods due to various reasons. Such reasons could include sub-par business models, poor managements, and sector related issues, amongst others.

In an attempt to try and narrow down likely performers from the ones that might not - from this pack of undervalued stocks - Joseph Piotroski, a Professor at the University of Chicago came up with a simple mechanism, well known as the 'Piotroski score'.

With the assumption that companies trading at cheap valuations are doing so for valid reasons, value investors bet on them in hopes of better times ahead. However, if the scenario does not change, it could end up being a bad bet. Considering that many of such companies tend to fold up or get de-listed due to poor financial conditions, the Piotroski score attempts to short list those which are likely to make a recovery or perform relatively better.

How the scoring system works...

The maximum a company can score in this method is 9. The higher the score, the better are the odds of the company not folding up. Companies are scored on the basis of nine parameters. One point is awarded for each parameter if the criterion is met. No points, if the criterion is not met.

The parameters are as follows:

  1. Return on assets - If positive in current year (CY; latest) then 1 point, if not then 0.
  2. Operative cash flow (OCF) - If positive in CY then 1 point, if not then 0.
  3. OCF/ Net profits - 1 point if operating cash flow is greater than net profits in CY, 0 if not.
  4. Long term debt vs. assets - 1 point if ratio has decreased on a YoY basis, 0 if not.
  5. Increasing current ratio - 1 point if ratio has increased on a YoY basis, 0 if not.
  6. Increasing asset turnover - 1 point if ratio has increased on a YoY basis, 0 if not.
  7. Increasing return on assets - 1 point if ratio has increased on a YoY basis, 0 if not.
  8. Share dilution - 1 point if there is no change, 0 if more shares have been issued.
  9. Increasing operating margins - 1 point if ratio is increased on a YoY basis, 0 if not.
We ran a query on stocks (not including financial institutions) from the BSE-500 index and came up with the following list. It may be noted that the results only include those companies trading at book value and below. We have ranked the stocks based on their Piotroski scores.

Company NamePiotroski scorePBV
Gujarat Alkalies & Chemicals Ltd.9.00.7
Amtek Auto Ltd.8.00.4
Onmobile Global Ltd8.00.5
Reliance Capital Ltd.8.00.7
Ybrant Digital Ltd.8.00.8
Noida Toll Bridge Company Ltd.8.00.8
Future Retail Ltd.8.00.9
SJVN Ltd.8.01.0
Zylog Systems Ltd.7.00.2
NCC Ltd.7.00.3
Titagarh Wagons Ltd7.00.5
India Cements Ltd.7.00.5
Manappuram Finance Ltd7.00.6
Bombay Rayon Fashions Ltd.7.00.9
Dish T V India Ltd.6.00.0
Geodesic Ltd.6.00.1
S Kumars Nationwide Ltd.6.00.1
Kemrock Industries & Exports Ltd.6.00.1
Shiv-Vani Oil & Gas Exploration Services Ltd.6.00.1
Vikas WSP Ltd.6.00.2
Data Source: ACE Equity

We would like to mention here that we are in no way suggesting any stock ideas through this article. Stocks screeners are just a method to help short list stocks, but are not sufficient enough reasons for one to buy into companies. A thorough and understanding of the company and sector is of utmost importance.

The Piotroski score is one that is purely quantitative as it uses data from financial statements only. And one that focuses on the data of recent years as compared to a long term history. Also, there are really no elements of qualitative factors in this process, something that investors cannot afford to ignore. One should also keep in mind that a company gets points on parameters even if they are poor when viewed in isolation or when compared to peers. A year on year improvement in numbers is mainly the factor that leads to a company getting a better score.

Nevertheless, one should not forget the broader idea behind this screener is to not get stuck in stocks of companies that never improve in their financial performance, thereby leading to value traps. As such, this tool could be one of the many starting points towards short listing value stocks, provided the pros and cons are clearly understood.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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