by Larry Swing - October 23, 2005

Education

Much academic work has been done in investigating the returns of stocks with differing book to market ratios (BM).  The existing evidence strongly suggests that low BM stocks outperform high BM stocks over the long run.

A 2000 study expanded on the prior BM literature by examining how low BM stocks performed for varying levels of "profitability, financial leverage / liquidity, and operating efficiency."  The study takes many measures of these factors, labels them as positive or negative, then counts the number of positives to determine the bullishness of the stock.

The profitability measures:

• Net income before extraordinary items (ROA)
• Positive if positive
• Cash Flow from Operations (CFO)
• Positive if positive
• Change in ROA (ÄROA)
• Positive if positive
• The difference between CFO and ROA
• positive if CFO > ROA

The financial leverage / liquidity measures:

• Change in firm leverage
• Positive if negative
• Change in the current ratio
• Positive if positive
• The firm raised equity
• Positive if false for the past year

The operational efficiency measures:

• Change in current gross margin
• Positive if positive
• Change in the current year asset turnover ratio
• Positive if positive

They show that adding these variables to a high BM strategy would have increased returns by 7.5% per year during their studied period from 1976 to 1996.

The study also compares the effectiveness of these measures in different trading liquidity, size, and analyst following groups.  The authors found the best results using the above criteria for high BM stocks that were illiquid, had no analyst following, or were small.

Reference:

Piotroski, J. 2000.  "Value investing: The use of historical financial statement information to separate winners from losers."

Analyses of Indices and Sectors

We are neutral on the indices and all sectors this week.

Analyses of Individual Stocks

VZ

• Bullish stochastic crossover
• Good volume spike on the reversal day

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GT

• Bear flag
• Bearish volume