I am a big fan of the work of Joseph Piotroski and his “F-Score” method for evaluation the financial health of a company. His research shows that scoring companies on nine fundamental points from the financial statements can help determine the likelihood of a stock to go higher.
His original research used F-Scores to sort stocks trading under book value to separate the potential winners from losers and showed it worked very well. Those with higher scores went up, while those with scores of 1 and 2 had a high likelihood of financial failure.
If, like me, you have ever opened a wine bottle with a claw hammer, you understand that most tools have useful applications beyond the original intent. I find that the same holds true of the F-Score. By sorting the stocks of companies located in the United States, I can develop a pretty good picture of current business conditions. The more companies we have doing better, the better the condition of corporate America and the economy.
I sat down this morning and took a picture as the third quarter nears a close.
There are currently 4,158 stocks worth more than $50 million in the database I use. I split them into thirds — those earning F-Scores of 1-3 falling into the “really bad” zone, those from 4-6 in the “blah” bracket, and companies earning 7 to 9 falling into the “business is booming” classification. The breakdown is pretty interesting, and it confirms my basic economic view that things are better but not good.
About 17% of the stocks in the screen are in the “really bad” zone. You expect to find companies like JCPenney (JCP) down here, but I was also surprised to see that some market darlings are disguising poor internals with rising EPS. Salesforce.com (CRM) scores just a 2, and Facebook (FB) has an F-Score of just 3. Investors in oil and MLPs should be aware that a lot of these names are now in the “really bad” classification when measured by the F-Score system.
The bulk of U.S. corporations fall into the “blah” zone with F-Scores of 4, 5 and 6. Companies like Netflix (NFLX), Apple (AAPL) and Microsoft (MSFT) fall here in the middle of the pack. They aren’t going broke anytime soon, but revenues and cash flows are not growing consistently. Until we get a real recovery with substantial job creation, business conditions — and the stock prices of these “blah” stocks — will probably just muddle along.
The “business is booming” classification includes companies like Starbucks (SBUX), Goldman Sachs (GS) and Activision Blizzard (ATVI), where business is doing just fine. Apparently no matter what happens in the world we still like our coffee and video games … and the investment bankers can always find something to do. The “business is booming” class should be on every investor’s radar screen, whether you are shopping for value or growth. The level of U.S. corporations that score an 8 or 9 sits at just 5%, which is one of the lowest marks I can recall. Only four stocks in the top 5% trade below book value — take a long look at Volt (VISI), Stratus Properties (STRS), Tropicana Entertainment (TPCA) and Burnham Holdings (BURCA).
Taken all together, 59% of U.S. stocks fall into the “really bad” or “blah” classification, while only 5% are hitting it out of the park right now. In addition to business conditions that can be described as broadly average, the valuation levels are not particularly cheap. I will just add these data points to my growing collection of red flags. But you can always find stocks worth owning if you know where to look.
At the time of publication, Melvin was long VISI and BURCA.