In my earlier post, I discussed the counterintuitive results of money-losing Net-Nets compared to their profitable contemporaries. We also discovered that high F-Score Net-Nets also appear to do better than the average. In light of promising results from fundamental momentum and, paradoxically, money-losing Net-Nets, I thought it would be interesting to deconstruct the F-Score into its three major components. And in so doing, to see if there are ways to improve upon the performance results of positive-earning Japanese Net-Nets.

In this post we will focus on the first signal, Profitability, with the intent to follow up on the other two signals in subsequent posts.

According to Piotroski, the Profitability signal attempts to provide information on two key components of a company’s operations: (1) the company’s ability to generate funds internally, and (2) the company’s earnings trend suggests an increased ability to generate funds internally in the future.

The signal is derived from the following four criteria:

• Positive earnings before extraordinary items (or positive ROA)
• Return on assets (ROA) in the current year greater than ROA in the prior year
• Positive operating cash flow in the current year
• Cash flow from operations being greater than net Income (quality of earnings)

Piotroski concludes that positive earnings and cash flow in the current year provides information about the company’s ability to generate funds internally. And an improving ROA year-over-year ROA suggests the company will continue to be able to generate funds internally. Piotroski also adds a fourth crieteria: company accruals. A few years prior to Piotroski’s paper, Richard Sloan published a paper highlighting the accrual anomaly. Sloan concluded that positive earnings driven by positive accrual adjustments is a bad omen.

Sloan Ratio = (Net Income – CFO – CFI) / Total Assets

To account for the accrual anomaly, Piotroski adds the criteria that a company’s operating cash flow should be higher than its reported income.

As noted, money-losing Japanese Net-Nets outperform positive earners. But what happens when we include the other 3 criteria of the profitabilty score?

To test this, I have chosen to select the names that score a 4 out of 4 on the profitability scale from our database of Japanese Net-Nets. By definition, this will include the positive earners, but will only include those names with a positive earnings trend, healthy cash flows and negative accruals.

Below is a summary of the number of stocks held each year. The basket size is larger than the high F-Score basket, except in 2017.

As might be expected, companies scoring a 4 out of 4 on the Profitabilty signal outperform the positive earners. This may be a valuable step in filtering through the positive earners.

However, when viewed against other strategies studied so far, it leaves us wanting. Using the Profitability signal only gets us back to the baseline return and underperforms against negative earners by a wide margin.

Thanks for reading!