Joseph Piotroski is an associate professor of accounting at the Stanford University Graduate School of Business. He developed the F-score in 2000 while at the University of Chicago. Piotroski recognized that, although it has long been shown that value stocks (or high book-to-market firms as he calls them) have strong returns as a group, there is nevertheless a very wide variability in terms of the returns of these stocks, with most of them performing worse than the market.
In his research paper called ‘Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers’, he noted:
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 [but] half of the firms languish; they continue to perform poorly and eventually delist or enter bankruptcy.
The F-score he developed essentially looks for companies that are profit-making, have improving margins, don't employ any (obvious) accounting tricks, and are strengthening their balance sheets. The score consists of nine variables are split into three groups:
- Balance sheet health, and
- Operating efficiency.
More information on exactly how the Piotroski F-Score is calculated can be found in Appendix 2. In our back tests we ordered our universe according to their F-score without taking into account the valuations of the stocks. We first wanted to determine if the F-score on its own is a strong predictor of market outperformance, because if so, it may be an even better predictor in combination with other parameters valuation factors, for example.
In the above table you can see that the F-score is a strong factor as we defined it. It led to market outperformance for all three company sizes and worked particularly well for mid cap companies. Also, the strategy outperformed the market 75% of the time for small and mid-sized companies, and 83% for large companies. The results were also completely linear.