How to find cheap shares that could outperform

How can you figure out the difference between a company in terminal decline and one that's fixed its problems and is bouncing back to health? For value investors, the reality is that some apparently cheap stocks never recover. And for investors in high quality stocks, the truth is that unexpected disasters can beset even the greatest companies.

To overcome these problems, there are tools at hand to help investors. One of them is a checklist designed to root out shares with the best chances of success - it's called the Piotroski F-Score.

A quality checklist

The F-Score was introduced in 2000 in a research paper by an accounting professor called Joseph Piotroski. His initial aim was to understand which stocks at the very cheapest end of the market were best placed to recover. But in the years to come, his methodology was picked up and applied as a general rule-of-thumb for finding high quality shares anywhere in the market.

Piotroski's work led to the creation of a nine-point accounting checklist - the higher the score out of nine, the better the financial strength trend of the stock. Crucially, it was designed to look back over a company's previous accounts and detect the most important signs of improvement or deterioration.

The nine checks are spread between three key areas of financial analysis. The first is profitability, where the F-Score examines operating profits and cashflow to ensure the business can sustain itself and even pay dividends. Crucially, these checks look for an improving trend in profitability, which in underpriced and potentially misunderstood stocks, can be a sign that a turnaround is underway.

Three of the nine F-Score checks look at the capital structure of a business, and can raise potential balance sheet red flags. They assess whether a company is improving its capacity to service both long and short-term debt, or if it is having to fund operations by issuing more shares.

Finally, the F-Score looks at whether the firm's operating efficiency is improving by looking for improvements in gross margins and asset turnover.

How the world woke up to Piotroski

In his own studies, which applied the F-Score to cheap shares, Piotroski's tests found that those with the highest financial strength often went on to outperform - on average by 7.5% annually over a 20-year backtest. Over time, his checklist was adopted by investment banks and equity analysts across a wide range of strategies to great effect.

At Stockopedia, we track the performance of a regularly rebalanced portfolio of high F-Score companies, and in the past two years it has produced an impressive return of 21.4%.

To get an idea of the types of companies with the highest F-Scores in the market right now, we adapted the screen for Interactive Investor. The table includes the relative price strength of each share against the market over the past year to give you an idea of how it has performed.

One of the interesting features of the screen is that the companies are generally quite small, ranging from the micro-cap Cambridge Cognition, to the £1 billion IT group, FDM. The small size is arguably reflective of the F-Score's focus on improving trends in financial accounts. It is scoring companies that have a track record of improvement, which you would typically find among smaller stocks.

Elsewhere, there are some well-known names here, including some that are recovering from problems, like Haynes Publishing, while others like FW Thorpe and Amino Technologies are widely regarded as good quality firms.

Overall, Piotroski's F-Score is a useful checklist for investors looking for an instant assessment of a company's financial health trend. High scoring firms tend to be strong, stable and profitable, with the potential to deliver predictable returns.

This assessment of fundamental health won't always provide a safety net from trouble, but for those looking for a way of assessing the trends in a company's financial track record, the F-Score could be a useful place to start.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.