Joseph D. Piotroski, an associate professor of accounting at the Stanford Graduate School of Business, developed a formula for determining a test’s accuracy.
He called it F-score which went on to be a widely used tool for weeding out underperformers and winners in a given situation.
In 2000, he wrote a paper which outlined nine fundamental criteria for picking winning stocks.
The strategy uses historical financial data to examine a company’s profitability, leverage, liquidity and operating efficiency.
Each of the nine criteria is worth one point. A company that meets all the criteria gets a maximum of nine points.
That means the more points it earns, the better the stock pick.
How does the F-Score approach work on Hong Kong shares? Will investors be able to pick outperforming stocks?
I have applied the approach in a back test of more than 100 Hang Seng constituent stocks.
The test shows that if an investor buys a stock with an F-Score of eight or nine after the company announces its annual results in April or May and holds the stock until the next year, he would be able to beat the return of other stocks and outperform the benchmark Tracker Fund (2800.HK).
A portfolio of stocks with F-scores of eight or nine had outperformed the Tracker Fund for eight out of 11 years as of the second quarter of 2014.
However, the portfolio lagged the benchmark fund by a mere 0.7 percent in the other three years.
How about the top 10 stocks with the highest F-scores?
By the end of April, these 10 companies had an average return of 19.4 percent, plus dividend, over the previous 12 months.
However, the return lagged a 31.9 percent rally in the Tracker Fund during the period.
The Tracker Fund has been driven by a few Chinese companies, state-owned firms and blue-chip stocks after the launch of Shanghai-Hong Kong Stock Connect.
Stocks such as Tencent Holdings (00700.HK) and Hong Kong Exchanges and Clearing Ltd. (00388.HK) have been massively targeted by hot money.
The F-Score approach can help pick good stocks but the high-score portfolio may not be able to beat the benchmark fund.
Investors might even end up losing money.
In fact, stocks with good fundamentals may not always outperform because there are other factors that could affect their performance.
These include the economy and government policy. Financial strength is just one factor that determines the stock price.
Nevertheless, the F-Score system offers investors an easy and effective way to sift stocks with good fundamentals.
At present, the market is mainly driven by liquidity as a result of supportive mainland policy. Also, there is rampant speculation on some small-cap stocks.
Investors need to calm down and examine the fundamentals of these stocks and not get swept away by a red-hot market.
As Warren Buffett famously said: “Only when the tide goes out do you discover who’s been swimming naked.”
This article appeared in the Hong Kong Economic Journal on May 28.
Translation by Julie Zhu
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