A little known accounting professor in the US has stgised an 8-step stock picking technique that boosts medium returns by 7.5% each year, according to his research paper. The technique targets profitable stocks that have been discarded by the market, which is nothing new; what is novel, however, is the fact that his simple strategy generated a 23% annual return between 1976 and 1996, and even overcome bear market selling pressure in 2008 to post stellar returns. Over the 20-year period under analysis, the stocks that scored the highest using Piotroski’s strategy beat other value stocks by some 7.5% each year, while stocks with a low score were up to five times more likely to file for bankruptcy or delist from the sharemarket.

The good news for investors is that his strategy does not rely on insider knowledge, expertise in charting or an understanding of advanced mathematics. To adopt his approach, you just need to get a hold of a company’s balance sheet.

The American Association of Individual investors admitted that Piotroski’s stock picking strategy was one of the few methodologies to yield returns for investors in bearish conditions. During 2008 the Association picked five stocks using Piotroski’s strategy – only to watch them soar by 33% on average throughout the year. The medium performance of other stock strategies selected was a miserly -42%.

Joseph Piotroski wrote a paper for the Journal of Accounting Research called “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” You can access it here.

The first step in the strategy is to screen for stocks with a low price-to-book value. Piotroski limits his search to stocks that have been sold off – wallowing in the bottom 20% on a price-to-book basis. These stocks are often referred to as high book/market stocks.

Quite a number of stockmarket studies pinpoint high book/market stocks as being a good starting point for further research. However there’s the problem of buying stocks that are sold off for good reason – the company is in financial trouble and the market is keeping its distance. Only a few stocks will be mistakenly sold off – and the strategy Piotroski proposes is a technique to catch them.

After screening for stocks that feature in the bottom 20% on price to book value, Piotroski screens for stocks that score nine points across the following criteria – with one point to each test the company passed.

The difficulty for stock pickers is to not fall into the trap of buying stocks that have prettied up their financial statements with creating accounting. That’s why he targets companies generating cold hard cash from operations rather than relying on net income, which can be boosted by once-off gains. In fact, he argues that a warning sign for investors is when a company’s net income is significantly higher than its operating cash flow as creating accounting is probably to blame.

He also wants to see that a company is becoming more financially stable and solvent demonstrated by declining long-term debt to assets, and an increasing current ratio (current assets divided by current liabilities).

Interestingly, Piotroski won’t invest if a company is increasing the number of shares outstanding as it means that due to dilution, shareholders are getting less bang for their buck.

1.    Net Income: Bottom line. Score 1 if last year net income is positive.

2.    Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.

3.    Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.

4.    Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.

5.    Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)

6.    Current Ratio:  Measures increasing working capital. Score 1 if CR has increased from the prior year.

7.    Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.

8.    Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.

9.    Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

The Scorecard – If a company has a score of 8 or 9 it is considered strong. If the score adds up to between 0-2 points, the stock is considered weak.

Indeed, its possible that very few companies manage to tick all the boxes and the ones that do are small, unloved and possibly unknown. But Piotroski is not worried by this, arguing that companies with low share turnover and no analyst following are actually better bets than market darlings.