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Picking tomorrow's winners today

In the second part of the series on celebrity investors' strategies, Sameer Bhardwaj tests Joseph Piotroski's method of picking unpopular stocks that have a high growth potential.

twitter-logo Sameer Bhardwaj        Print Edition: Nov 14, 2010

Retail investors often favour stocks that are established in the market, those with high market capitalisations and recommended by analysts. However, there are certain stocks that have the ability to outperform the market but remain obscure because their businesses are in the early stages. How does one identify such companies?

In the second part of this series on celebrity investors' strategies, we focus on Joseph Piotroski. He gained fame for his methodology of selecting unpopular stocks that have the potential to become winners. In 2000, while teaching at the University of Chicago, Piotroski came up with an academic paper on investing that was highly acclaimed. His research focused on companies that had high book to market (B-M) ratios, or stocks whose book values (total assets minus total liabilities) were higher than the values (measured by market capitalisation) accredited by investors.

However, there can be genuine reasons for a low market value, resulting in high B-M ratios. For example, investors could have shunned a stock because of a financial crisis in the company. But according to Piotroski, the key is to focus on high B-M stocks. Such stocks can be great investments because their share prices are likely to jump once the market recognises their potential. After selecting stocks with high B-M ratios, Piotroski applies a series of balance sheet and accounting measures to choose profitable options. The factors he uses to zero in on superior stocks are return on assets (RoA), cash f low from operations, net income, debt to asset ratio, gross margins, outstanding shares and asset to turnover ratio.

We analysed the figures for 2008-09 and found six companies, all small-caps, that satisfied Piotroski's criteria. We compared the price performance of the six-stock portfolio with the BSE Small-cap Index between March 2009 and July 2010. If Rs 10,000 had been invested in each of these six stocks on March 31, 2009, the portfolio's value would have grown to Rs 2,15,428 on July 30, 2010. This indicates that the portfolio had an absolute growth rate of 259 per cent compared with the 188 per cent delivered by the BSE Small-cap Index.

We repeated the exercise with 2007-08 numbers and found five companies that satisfied the criteria, again all small-caps. An investment of Rs 50,000 in the five-stock portfolio on March 31, 2008 would have grown to Rs 69,115 on July 30, 2010. The absolute growth rate of the portfolio would have been 38.23 per cent in comparison with the 19.22 per cent delivered by the BSE Small-cap Index.

Piotroski's strategy has delivered market-beating returns in both portfolios. We also tested the method using 2009-10 figures, shortlisting nine companies, and evaluating their performance between March and July this year. As in the 2007-08 and 2008-09 portfolios, the companies are small-caps. An investment of Rs 90,000 on March 31, 2010 would have grown to Rs 1,06,783 by July 30, 2010, an absolute return of 18.64 per cent. The BSE Small-cap Index generated 10.02 per cent over the same period.

In fact, five of the nine companies in the 2009-10 portfolio are turnaround firms. For example, Kandagiri Spinning Mills suffered a loss of Rs 2.6 crore in 2008-09 but recorded a profit of Rs 3.3 crore in 2009-10. Also, Panasonic Battery India suffered a loss of Rs 9.6 crore in 2008-09 but showed a profit of Rs 7.2 crore in 2009-10.

Investments in small-cap companies are considered risky as they are highly volatile. Such stocks also witness greater speculation. Therefore, it is extremely difficult to pick quality stocks from the small-cap universe. Piotroski's strategy not only helps in picking quality small-caps but also a portfolio that beats the market. However, he says the strategy works best for a holding period of one to two years.

Courtesy: Money Today

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