New HG buys and update

My newest Hidden Gems are OYOG, SCSS, MIDD and NATH. Each of these have specific reasons for being bought, but unlike past buys, they didn't really have much to do with the company itself after my own research. The point of HGs is that they are supposed to be promising companies as determined by the pros over at Motley Fool. Nevertheless, as JG says, never trust anyone over 30, and never trust anyone under 30, either. But still, the reasons for these purchases might be a little weak if I didn't have some trust in HG picks. Here they are: OYOG is only slightly above the recommended buy price from a few months ago. SCSS and MIDD are two of the three strongest recommendations that HG'ers have made. They keep on re-recommending them, and also they are on the HG list of best places for new money. This isn't what convinced me, though. It was that they have high Piotroski F-Scores. Finally, NATH is a Tiny Gem (below the official HG radar, like ALDN), but it is on the current list of MFI picks and has 16% ownership by insiders.

While we're on the topic, here are the updates of my three portfolios. MFI is trouncing the indices. Even the new purchases are kicking in, with a great week for ASEI, up 10% in my first week of ownership, after it got a big contract from the Department of Homeland Security. DECK also had a great week, pushing past the 52-week high for ~5% gain. Finally, ISNS is recovering from its slump: from -12%, it is now only -4%.

For HG, IIVI and ALDN are doing great, CTRP is flutuating wildly, and SDA is recovering from its initial loss. The new purchases haven't had time to do anything yet, other than dilute my apparent gains (the initial set is up 12.3%!).

The Biotech portfolio is doing nothing special, down 3%. ALNY and ARNA are up, and ARNA is doing especially well, although these are both on no news. NOVC has recovered slightly, and CBST went up to nearly even, and has now fallen slightly again.

Finally, over Thursday and Friday, it was announced that the shareholders of LPMA and PAY had all voted to go through with the acquisition. I was a little surprised that the share price didn't go up on Thursday after LPMA made their announcement, and very surprised that after-hours trading of LPMA on Friday, after the announcement by PAY, didn't shoot the stock up, either. But we'll see - on Monday I'll be shocked if it isn't trading higher.

My first experiment in finances

I've been reading the paper by Piotroski about value investing. In it, he shows that a number of characteristics of companies are good indicators of whether they'll be profitable in the next year, and that all of these characteristics can be found in their most recent year-end report. Every company has a binary indicator for each characteristic, and the sum of these indicators is the Piotroski F-Score.

1) Return on Assets (net income before extraordinary items) - if positive, then 1, otherwise, 0.

2) Cash flow from operations - 1 if positive, 0 otherwise.

3) Change in ROA from the previous year - if change in ROA > 0, then 1.

4) Accrual is measured as ROA - CFO, and is 1 if positive.

5) Change in the ratio of long-term debt level to average total assets is 1 if negative.

6) The Change in the ratio of current assets to current liabilities is 1 if positive.

7) If the company did not offer additional equity (did not dilute the number of outstanding shares), they get a point.

8) If the change in current gross margins scaled by total sales is positive, then 1.

9) If the change in asset turnover ratio is positive, then 1.

Piotroki showed that the sum of these is indicative of how well a company's stock price will perform in the following year. He also showed that small-cap stocks are more likey to do better (or do better by a wider margin, on average), and that no analyst coverage was also predictive of better success.

So, I wondered how does the Piotroski F-Score correlate with MFI ranking? And with market cap? I took the current top-100 MFI stocks at $1M and $2B minimum market cap cutoffs, and compared the distribution of Piotroski F-Scores to that of a sample of random stocks generated from a random stock generator. I think that the real result is more questions than answers. Anyone with access to COMPUSTAT and some means to test hypotheses using backtesting of data, take note.

A few additional points:

• I don't know how random the generator was: in a sample of 180-odd stocks, there were five repeats. This seems high considering the sample size relative to the total universe of stocks.
• Piotroski F-Scores were found using an Excel Add-In; in some cases it returned an error. So the actual sample sizes were: $1M - 78; $2B - 92; Random - 94.
• The $1M portfolio simply includes the top 100 stocks in the current MFI screen, with the range of market caps from $15M (ANTP) to $14B (NUE), with a median value of $439M.
• The $2B porfolio has a range of market caps from $2.013B (HNI) to $384B (XOM - Exxon Mobil), with a median value of $5.59B.
• The randomly-generated portfolio had a range of market caps from $7.4M (VERT) to $60.8B (QCOM - Qualcomm), with a median of $187M.
• What is the statistical significance of this experiment? In order to be truly confident in these results, in other words, to be sure that the different distributions are not soley due to chance, this experiment should repeated some large number of times, say 1000. I think that a t-test might be valid, but I also think that there might be a problem because the MFI portfolios have a skewed (rather than perfectly normal) distribution. In case they are valid, I'll just mention that the P-vaues for the $1M and $2B portfolios, as compared to the random portfolio, are 0.0005 and 5e-12, respectively.

Click on the figure to expand it. The group of random stocks is pretty much normally distributed, while the $1M and $2B MFI stocks are right shifted. There were no stocks in the $1M portfolio with a F-Score less than 2, and none in the $2B portfolio with a F-Score less than 3. The $2B portfolio is skewed towards higher F-Scores.

It makes sense that no MFI stock has a 0 or a 1 F-Score: MFI stocks have a high earnings yield and return on invested capital, which should be closely related to accrual (or maybe CFO) and ROA. But, it is surprising that the large cap portfolio is the one that is further right-shifted than the total MFI portfolio. Both Piotroski and Greenblatt concluded from their analyses that small cap stocks are better performers when selected by their respective methods. So why does a broader portfolio score worse than a focused, high market cap portfolio? What's the difference between Piotroski and MFI? I think that the difference is important, actually. MFI uses two characteristics, but the ranking system lets the screen scale the potential performance of the stocks. In other words, the one stock with a F-Score of 2 probably scored really highly on those two characteristics - but the F-Score fails to take that into account because it is based on binary analysis for all of its characteristics. Is there some way to combine the two approaches? Sure. For every stock, rank it for each Piotroski characteristic. Combine the rankings for an ordered list, like in MFI.

Is this necessary? Maybe not. Greenblatt argues that EY and ROIC are the major determinants of performance. And I think that MFI and Piotroski analyses are supposed to give comparable returns - possibly even MFI is superior, I think. So is Piotroski diluting the effects of the MFI characteristics by including the 7 other characteristics? What are the relative effects of each Piotroski characteristic? Rerun the Piotroski analysis 9 times, but for each rerun, make one of the characteristics worth 3 instead of 1. If this results in superior outcomes in terms of portfolio change, then you've identified a more important characteristic. This can be confirmed by systematically dropping one characteristic from the Piotroski F-Score, and looking for an increased drop in portfolio returns relative to dropping any of the other characteristics.

Finally, how does this affect my stock buying strategy? I'm not sure so far, because I'm not sure that I want to mess with something that's working. My current MFI strategy is:

• Pick stocks from the top-100 stocks with a minimum market cap of $1M.
• Buy 5 stocks every 2 months.
• Prefer stocks with recent insider purchases.
• Prefer stocks that have high insider ownership.

I'm considering adding the following rules:

• Only buy stocks with a high Piotroski F-Score.
• Only buy stocks with low or no analyst coverage. I rather like this one, as it typically means that Mr. Market has a worse idea of how to value any given stock.

I suspect that few stocks will meet all of these rules. This might involve checking the MFI top 100 more often than every 2 months and buying whenever I find a stock that does meet all of these criteria.

A homegrown screen?

Using the Fidelity stock screener, I made a stock screen based more-or-less on MFI principles (I think - I leant someone the book), along with some of my own:
1) Small cap (<$1.8B)
2) Highest 20% in the market for Earnings Yield
4) Top 40% in the market for each of Return on Equity, Return on Investments and Return on Asests
5) Lowest 20% Institutional Ownership
6) Highest 20% Net Insider Purchases
7) Covered by 4 or fewer analysts.

I came out with three companies. And the winners are...

Second Round of MFI

The time has come for my second round of MFI picks. So, here they are:

WNR: Western Refining produces fuel in West Texas, Arizona and New Mexico. The company recently announced the buyout of Giant Industries, which I think is now their only source of debt. They first went public in January at ~ $18, now trade for ~ $22. Insiders have recently bought a ton of shares, and I got to buy at a lower price than they did.

ASPV: I had seen articles about this company when I started investigating my new purchases a couple of weeks ago. I was really excited about Aspreva: they are a drug company that takes approved drugs and determines whether they can treat new indications. Then thstreet.com published an article on them, and the share price shot up about 10%. I'm only a little less excited. They are a profitable drug company which is probably very undervalued: their PE is ~ 8, compared with other profitable drug companies like Genentech (PE = 53!), Bristol Myers (PE = 16), GSK (PE = 18) and TEVA (which sells generics of drugs, like Pfizer's Zoloft, PE= 234!). Insiders haven't bought recently, but they already own ~ 65% of the company! How much more could I hope for them to buy? Debt is less than 1% of their cash on hand, and they've got a (small) pipeline for new products. An exciting company.

ASEI: They make x-ray machines that are used in airports. Some of the various machines that they produce are supposed to detect all sorts of prohibited items. Unfortunate that this is a growth industry, but it is. This company was a Hidden Gem bonus pick several months ago, when it was at $69, and originally it was a Rule Breaker pick. They've reported less-than-predicted earnings lately, and that's made the stock price tumble. The lumpy earnings is supposed to be normal in the industry, but Wall Street responds in the short term, so one poor quarter makes this a buying opportunity. Also, I'm not quite sure how to interpret non-open market purchases by insiders, but ALL of the principals bought at over $50 in June.

PWEI: They make pipes and fittings for commercial and industrial plumbing. A perfectly boring industry! Just like Lynch recommends. BUT a hedge fund is buying tons of the company, and really shaking the boat. AND they're called PIRATE Capital - how much better does it get? This hedge fund is apparently known for shaking things up in order to increase shareholder value. On top of that, the company authorized a $40M buyback despite the fact that the share price has gone up nearly four-fold in about the last year. It's gone up that much, but the board still thinks its so undervalued (PE is under 5!) that the best way for the company to increase shareholder value is to buy back shares? That's encouraging.

UEPS: They're bringing debit cards to underdeveloped societies. Seems like a lot of growth is possible. Debt is nil, insiders hold 31.3% and one of the diretors recently bought a ton more. Looks good.

A couple of notes:

It will soon be time for my next round of Hidden Gem picks, so stay tuned! Also, it was announced that the second-to-last hurdle for the PAY acquisition of LPMA was cleared: the DoJ said that there are no antitrust concerns. Now as long as all of the shareholders vote the right way... Finally, BLD was in a slump, but then an analyst ranked them as a strong buy and they shot up! From about -12%, they are now about +2%. In all, my initial 5 purchases are up ~15% total.