In my previous post, we took a look at the first subset of signals of the F-Score: Profitability. Contrary to Piotroski’s conclusion that profitability and positive cash flow are the key drivers of performance, Japanese Net-Nets do not appear to behave in a similar manner on profitability signals. When it comes to Japanese Net-Nets, quite the opposite is true. Negative earners significantly outperform companies with positive earnings and positive cash flow.
Although we saw that the backtest for the high F-Score shows promising results, profitability signals do not appear to be the key drivers. I am curious to know if there might be other particular signals that drive the performance of Japanese Net-Nets.
In a continuation of the study on the F-Score, the second of the three subsets within the Piotroski F-Score are three signals designed to measure leverage, liquidity, and source of funds.
Piotroski’s working assumption is that an increase in leverage, a decrease in liquidity, and the use of external financing are bad omens. Of course, Piotroski acknowledges that, taken in isolation, these signals are quite ambiguous. For example, an increase in leverage can result in either positive or negative outcomes for a company. An acquisition, a product-line expansion, or simply access to cheap capital are some of the many examples that could lead to positive economic outcomes for the company that takes on added debt. However, the central premise of Piotroski’s study of low price-to-book stocks is that these companies are financially distressed at some level. Given this presumption, it makes sense for Piotroski to conclude that these signals would lead to negative outcomes, on net.
Again, the fly in the ointment is that Japanese Net-Nets are not financially distressed. On the contrary, their balance sheets are overcapitalized resulting in poor returns on capital. It is therefore difficult to come to the same conclusion. Perhaps the opposite is true: Japanese Net-Nets that score poorly on capital structure have better performance.
According to Piotroski, the Leverage, liquidity, and source of funds signal attempts to provide information on two key components of a company’s operations: (1) to measure changes in the capital structure, and (2) to measure the firm’s ability to meet future debt service obligations.
The signal is derived from the following three criteria:
As mentioned in previous posts, Piotroski uses fiscal year numbers. For my study, I use TTM numbers. Also, in my study, I use the change in diluted common equity, not issuance. If the diluted shares outstanding in the most recent quarter is less than the shares outstanding in same quarter of the previous year, the signal scores a one, zero otherwise.
To test for these performance signals, I have grouped stocks that scored a 3 out of 3: a decrease in debt, an increase in the current ratio, and a decrease in shares outstanding. To test for the lack of a signal, I have grouped stocks that scored a 0 out of 3.
Below is a count by year of each cohort. I’ve included the high F-Score cohort as a reference. There are of course some immediate concerns with the study. Aside from small sample sizes, many of groups are not represented in each year. For groups scoring 3 out of 3, they are not represented in 2010 and 2011. For groups scoring 0 out of 3, they are not represented in 2015, 2016, 2017, and 2018, or 4 years of the 14-year study. And the high F-Score does not have representation in 2016, 2018, and 2021.
Given the constraints, the study assumes that no positions were held in a year that failed to produce any positions. It is up to you to make assumptions on the performance for the years left out. The results below, for equal-weighted positions, show cumulative returns that are about the same for each group.
The stocks that have increasing leverage, rising shares outstanding, and declining liquidity offer a much bumpier ride, and aside from a couple of big years, do not appear to be promising holdings. For example, in 2014, you would have held only one stock: Future Venture Capital Co Ltd. The payoff, of course, was big: up 440%. But this could have been random luck and who wants to hold only one stock.
| Observation | 580 |
| Symbol | 8462.T |
| TR.CompanyName | Future Venture Capital Co Ltd |
| TR.gicssector | Financials |
| Start Date | 2014-04-20 |
| End Date | 2015-04-20 |
| TR.F.PeriodEndDate | 12/31/2013 |
| Start Date – TR.F.PeriodEndDate (in days) | 110 |
| Start Price | 160 |
| TR.DPSActValue | 0 |
| End Price | 865 |
| % chg | 4.40625 |
When stacked against the high F-Score and the baseline portfolio, neither cohort looks very promising.
Based on this study, parsing out stocks based on their capital structure and ability to meet future debt obligations does not appear to aid in stock selection.
Next we will take a look at the last performance signals: operating efficiency.
Thanks for reading!