I achieved a few F’s in my higher education days, and I was never too proud about that. But nowadays, getting a good F grade is pretty awesome.
As a value investor, I am always trying to improve my analytical skills and see if there is anything I can add to my Investment Checklist that will help me find better value stocks and help me improve my odds at a successful investment.
I was taking a look at the Stock Screens on the American Association of Individual Investors website (AAII.com) and this F-Score stood out to me.
The AAII post the returns of hypothetical portfolios based on 75 well known investors using their investment strategy.
Out of all 75 Stock Screens on AAII.com, the F-Score ranked the third best performance since inception (over 10 years) with an annual Rate of Return of 23.7%.
It was ranked Number 1 of all Value Investing strategies
Using the Rule of 72, it will only take 3.03 years to double your portfolio with the historical returns from the F-Score. 72/23.7 = 3.03
The F-Score was created by accounting professor Joseph Piotroski from Chicago University School of Business.
The F-Score is used to determine the best value stocks by looking at 9 criteria on the Financial Statements.
This is used to determine the strength of a firm’s financial position in the current year compared to the previous year.
Of the 9 criteria, a scoring system is used to rank each company.
A score of 1 point is awarded for each of the 9 criteria that improved from the previous year.
If one of the criteria did not improve from the previous year, then no point is awarded.
The best score is 9 while the worst score is 0.
Here are the 9 Criteria that make up the F-Score
- Positive Return on Assets compared to previous year. Financially sound companies should be profitable.
- Positive Operating Cash Flow compared to previous year. Many people believe that cash flow is a better gauge of the company’s true financial situation as cash flow is harder to manipulate than earnings. Also, a positive cash flow will tell you if the company has the cash to keep the day to day operations going.
- Higher Return on Assets in the current year compared to previous year. This tells us if the company is improving its profitability. If so, great! If not, it could signal that there are problems to come.
- Cash Flow from Operations are greater than Net Income. This helps to separate companies that could be playing accounting tricks with their reported earnings. Since Income has taxes and depreciation subtracted from it, cash flow is usually larger than net income. If not, it could be a sign of earnings misrepresentation.
Leverage, Liquidity, and Source of Funds
- Lower ratio of Long Term Debt/Total Assets compared to previous year. We are looking for companies that are reducing their debt or increasing their assets or both.
- Higher Current Ratio compared to previous year. This ratio gauges the firm’s liquidity (available cash on hand). If they are liquid, then they have plenty of cash to pay their debts. The higher the ratio, the more liquid the firm.
- No new shares were issued since the previous year. Issuing new shares dilutes the value of an existing investment, but if they issue more shares it could also mean that the company can’t cover its current liabilities which is another sign of trouble.
- A higher gross margin compared to previous year. Gross margin is the percentage of revenue that’s left over after paying the costs of producing the goods sold. A higher gross margin means the company is becoming more efficient and is expected to be more profitable.
- A higher asset turnover ratio compared to previous year. This is a measure that the company is able to make more sales with their assets. This is another measure of improving efficiency.
If you want to do all of this work manually, then good for you. But you don’t have to.
Go to gurufocus.com, enter a ticker symbol, and the score is on the main summary page for you.
We are looking for companies with a score between 7-9.
6 may be acceptable if most of the other items on the Investment Checklist look good.
Lower scores could mean that a moat has been broached. That is a red flag. However, the numbers tell us a lot, but not everything. If it has a poor F-Score it could be a temporary problem. Let your research tell you that by reading the annual and quarterly reports and industry reports too.
Here is the F-Score on Gurufocucs.com for American Outdoor Brands:
They currently have an F Score of 7.
There are many things that I have on my investment checklist. They are all there for a reason. We want to put as many odds in our favor of having a profitable investment and the F-Score is one of my favorite items on that checklist. I hope you use it.