How This 10-Step Value Investing Checklist & Mindset Helps You Get Better Returns

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In this article, I will provide a Value Investing Safety Checklist that you can follow easily.

I will also provide you a mental framework (mindset) that you should understand first since it affects your ability to gain superior returns.


“No wise pilot, no matter how great his talent and experience, fails to use his checklist.”


Charlie Munger, Vice Chairman of Berkshire Hathaway

Combined, this Mental Framework and Value Investing Checklist should remove personal biases from the equation while helping you avoid financially weak companies together with identifying under-valued, financially strong companies.

In turn, this can help you avoid serious financial losses while outperforming the market.

Mental Framework

What separates successful investors and people who make losses in the markers?

Successful investors are able to differentiate between “perceived exchange in value” and “actual value“.

What do I mean?

As human beings, we have been trained to commit to “perceived value”.

You commit to such an exchange whenever you pay for coffee, food, an insurance plan, an air ticket, a new phone.

You commit to such an exchange whenever you spend your time with a date, whenever you decide to work out, read, learn a skill or go on a trip.

Or at least that is what you believe.

The truth is that the daily commitments you make with your money is NOT a fair exchange in value in the slightest.

Maybe sometimes it is. But in 90% of the transactions you make every, single day – it isn’t.

You don’t go to that shop for chicken rice because it is the best exchange in value. You go there because it is the most convenient though lacking in taste. Or the most tasty but also more pricey. Or the one that’s cheap but clearly miserable to eat.

At that point in time as you make your decision, you’re not actually ascribing value to the chicken rice but rather the time, taste, or convenience of consuming it.

You don’t always go to Kopitiam because it is a “fair exchange in value“. You go because the place has air-con, or because you have a Kopitiam discount card, or because your colleagues wanted to eat there. Or because you have a craving for Pepper Lunch.

To you, the need for a “fair exchange in value” is superseded by the need for a cool place, companionship, and a taste you can’t find elsewhere.

You didn’t buy that insurance plan because it is a “fair exchange in value“. It is simply the insurance plan you have spent two hours talking about with your best friend from primary school who out of the blue called you up for coffee two weeks ago.

You buy the plan because it’s nice to help a friend out while keeping in touch, because you want to believe they have your bests interests at heart, and because at the same time, it fulfils the need to protect yourself if something ever happens.

To you, these feelings of emotional satisfaction matter far more than the “fair exchange in value” itself.

But you’re not truly aware of it as you hand over the cash at the counter and sit down with your plate of food. All of the above reasons are not a “fair exchange in value” in the slightest.

You simply perceive it to be. That is perceived value.

The first part of the problem is that your surroundings, and the world you have lived in have continuously trained you, rewarded you, and continued rewarding you, for the choices you have made in terms of exchanging your time and your money for “perceived value” and emotional satisfaction.

You get satisfaction from the choices you make, irrespective of whether or not it was a “fair exchange in value.”

You sigh in relief at the air conditioning.

At the lack of the queue.

At the taste of the food you have craved.

At the discount you have received.

The problem compounds when you bring that same set of attitude and beliefs that you have been rewarded for your whole life – and thus something that is difficult to change and even be aware of in the first place – to the world of investing.

  • You buy that stock because it’s a blue chip and “safe”. As if somehow that excludes it from failure.
  • You buy it on the basis of your friend’s recommendation because you trust him.
  • You buy it because you like its management. Never mind the business fundamentals.

And then the inevitable happens.

The business fails to perform.

The stock price dips or plunges on the back of falling revenue.

Companies collapse.

Your portfolio disappears into thin air.

Because in the world of investing, you’re not rewarded for choosing something that satisfies you emotionally – and this is made more difficult by the fact that you have been trained everyday to satisfy emotional needs.

This sudden reversal of how the world works becomes a painful and excruciating experience – one that would have forced most people away from the markets after their initial loss.

  • That is why you need to learn to value the business and its financial fundamentals instead of looking too closely at the name.
  • That is why you need to understand how to detect your own underlying bias towards a brand.
  • That is why you must learn to separate facts from perceived truths.

Because if you fail to do so, only failure and the loss of your money waits.

Now that I’ve sufficiently pointed out WHAT to do, and WHY you must do it, you must learn HOW.

Value Investing Checklist: Modified Piotroski 9 Point F-Score & Price to Book Ratio

This checklist will do two things for you.

  • It will eliminate companies with poor financial strength you should never consider investing in.
  • It will detect value stocks with strong financial strength worth your consideration and time.

These 9 points rate a company’s:

  • Profitability (4 points)
  • Leverage, Liquidity and Source of Funds/Abbreviated as LL&S (3 points), and
  • Operational Efficiency (2 points)

Altogether, if the company scores 9 points, it is in a strong financial position. It is considered weak if it scores 0 points. You should look to invest only in companies that have scored 9 points.

You can assess companies more quickly by first assessing their Leverage, Liquidity and Source of Funds. If they fail to have a 3 point score there, eliminate them from consideration.

Let’s dive in.

Piotroski Criteria 1: Positive Net Income (Profitability)

This is straightforward.

  • Is the company making money or not?
  • Did it make more money this year than the last?
  • Has it’s net income been dropping for the past few years?

If it has scored more net income this year than last year, give it one point.

Piotroski Criteria 2: Positive Return on Assets (ROA) in the current year (Profitability) 

Formula:

Return on Assets = Net Income / Total Assets

Logic:

This will measure a company’s ability to make money with the assets they have.

If ROA has been going up over a number of years, it is a good sign. If it is going down consistently over a number of years, it’s a bad one.

Additional Comments:

A company with rising ROA can be said to be gaining market dominance. Or at least it is able to gain better efficiency in getting revenue for every dollar they use. Both of which are good things.

A good way to further use ROA as a measuring stick for a company is to hold a company’s ROA against its peers and competition in the same industry.

If you’re comparing between two Real Estate Investment Trusts (REITs) of equal sizes, all else being equal, you can at least base your decision on which has had a history of increasing ROA, or a larger ROA.

Remember that since this criteria measures Return on Assets, it is best not to compare a construction company to a digital marketing company.

Going deeper, a major renovation firm should not be compared to a property developer.

Always compare apples to apples. And make sure they’re the same coloured apples.

A construction company would require manpower, vehicles, heavy equipment, licensing, adequate materials and an office. The digital marketing company might not even need an office. Just computers and an internet connection. Thus the ROA criteria favours companies light on assets and this must be accounted for if you compare companies.

Special Note:

You can use this to evaluate REITs. And remember that this ratio of efficiency by itself is useless. You must learn to measure a company’s ROA against its compatriots in a similar industry.

How to Score

Score one point for the company if company satisfies all requirements.

  • Company ROA is not worse than the average in their industry.
  • Company ROA has held steady or is increasing compared to the average of its lifelong operations.

Piotroski Criteria 3: Positive Operating Cash Flow in the current year (Profitability)

Logic:

If a company doesn’t have positive operating cash flow, then it will have trouble paying rent, paying supplies, paying manpower, paying utility, paying cost of operations.

Worst case scenario, the company shuts down. This is not an acceptable risk as a value investor.

Explanation and Comments:

Cash flow is typically the source of dividends. If a company has weak cash flow because of management or other issues, it is likely that it will not be able to pay dividends on time either. Starhub is a good example of a popular bluechip stock that had to slash its dividends which then caused their stock to lose 12% in value. This is not acceptable as a value investor.

If a company can somehow pay dividends even when experiencing negative cash flow, it is likely that the company will face troubled times ahead. Also, such a move has generally been highly correlated with a depression in future stock prices within the next 3-6 months.

Example:

Imagine the taxi uncle who has to wait to collect his commissions from Grab at the end of the month every month. He could be busy day and night, sending visitors everywhere, magically having customers 24/7.

But without cash, he would be unable to top up his gas tank. If his headlights or taillights malfunction, he would still be unable to continue running his business.

Even drug lords need to pay their runners. Hence why governments freeze financial assets and hence also why drug lords keep their earnings in cold hard cash.

How to Score:

Score one point if company satisfies all requirements:

  • Company has positive operating cash flow in the current year.
  • Company cash flow has held stable throughout years of operation or is increasing.

Piotroski Criteria 4: Cash flow from operations being greater than Net Income (Quality of Earnings). (Profitability)

Logic:

Cash flow from operations being greater than Net Income is a measure of quality of earnings. If it is higher, than you have good quality of earnings.

Explanation:

Quality of earnings is important to determine because of cash flow.

Here’s an example. Uncle Tan sells chicken rice.

Deliveroo pays him at the end of the month. That sale from the chicken rice is already registered under net income.

But the cash flow statement won’t see it yet because the money is still with Deliveroo. In companies where cash is tight, even minor unforeseen events can crush the company’s operational abilities. If somehow a batch of chicken goes bad, the uncle won’t be able to operate his business for a month!

Can you imagine a logistics company being unable to pay for shipping products?

Or Macdonald’s being unable to pay for their burger deliveries?

Only disaster waits. And by disaster, I mean you losing your money.

Remember:

If the company has poor quality of earnings or is unable to claw back money from their customers (as in the case of shipping). It doesn’t matter how much revenue they make. They could still choke and the business can still go under.

Piotroski Criteria 5: Lower ratio of long term debt in the current period, compared to the previous year (LL&S)

Logic

Reduced long term debt means more cash for the company and less liabilities in the event of revenue/business slowing down.

Example:

A REIT that has lower long term debt has a decisive advantage over one that is highly geared (debt-wise.)

Industry regulations require that REITs have no more than a 45% debt ceiling.

If a REIT has lower than 45%, they can actually increase their debt to fund purchases or expand revenue growth as opposed to one that is at 45% and will need to issue new shares and dilute current shareholder value.

Remember:

Reduced long term debt is good.

How to Score:

Score one point if company has reduced long term debt compared to the previous year. Debt that is longer than one year is deemed longer term debt.

Piotroski Criteria 6: Higher Current Ratio (Current Assets/Current Liabilities) this year compared to previous year. (LL&S)

Logic:

Similar to reduced long term debt, except this measures a company’s ability to pay its liabilities. The less liabilities the better. You can find current assets and current liabilities under the company’s financial statements.

How to Score:

Score one point if company has a higher ratio of current assets against current liabilities compared to the previous year.

Piotroski Criteria 7: No new shares were issued in the last year (LL&S)

Logic:

Companies issue new shares to raise funds. That they didn’t need to resort to issuing new shares means they could secure funds without prohibitive cost or that they didn’t need to in the first place. Both of which are a good sign.

Example:

If a business originally had two owners, both owners had 50% ownership. Both owners will therefore also get 50% of the dividends.
If the company had to issue new shares in equal share ownership to a new partner, then both original owners will now only have 33.33% ownership of the company, and now, they’re only allowed to have 33.33% of the dividends as a result. The same translates to their shareholder values.

Remember:

As Value Investors, we want to avoid the value of our shares being diluted or being forced to pay for new shares as the company requires funds.

How to Score:

Score one point if the company has issues no new shares in the last year.

Piotroski Criteria 8: Higher gross margin compared to previous year (Operational Efficiency)

Formula:

Gross Margin = (Revenue – Cost of Goods Sold) / Revenue

Logic:

Higher gross margins can have its sources from many things but overall, higher gross margins mean bigger profit margins. Bigger profit margins is a definite good thing.

How to score:

Score one point if company has has a higher gross margin compared to previous year.

Piotroski Criteria 9: Higher asset turnover ratio compared to previous year. (Operational Efficiency)

Formula:

Total Sales / Total Average Assets

Logic:

This is similar to Return on Assets in that it measures how efficiently the company is generating revenue per dollar of assets. The higher, the better. Compare both Return on Assets and Asset Turnover Ratio to previous years. Make sure it has not been going down steadily over the past several years.

How to Score:

Score one point if the company’s asset turn over ratio was better than it’s previous years.

Additional Criteria 10: Price to Book Ratio (Value)

Price to book ratio is thankfully available under Yahoo Finance. Most stocks brokers will also have a display for the stock’s price to book value. The ratio tells you how much you’re paying per dollar for each dollar of the company.

If the company’s PB Ratio is 0.7, you’re paying 70 cents for every dollar that the company is worth. In this case, the bigger the discount, the better. I would personally take a serious look at companies with a Piotroski Score of 9 with low PB ratios.

The lower the PB ratio, the better it would be. Do not buy companies with a PB Ratio of more than 1. This PB Ratio discount will provide you a margin of safety and add to the potential profit you can have.

Ideal Price to Book Ratio: As low as possible. Nothing above 1. A ratio of one means the company is already assessed to be reflecting its true value. You want to buy undervalued companies. Not companies which shares already price in the strong financials.

Execution and Implementation

Note that you do not have to calculate all of this by hand. Financial brokerages or stock screening services typically have price to book ratio available.

There are subscription based Piotroski F-Score Screener services that can assist you in quickly sifting out companies to look at. Google them.

As stated above, first check the company’s Liquidity, Leverage, and Source of Funds Score. If it fails, there is no need to consider checking further. This will save you time and energy.

Second, check whether it falls below a Price to Book Ratio of one. If it is above 1, then its financial strength is already reflected in price of the company’s shares. It will be more difficult to find value there. Don’t investigate further if the company’s P/B Ratio is 1 or above.

Third, if it passes, these 2 inital steps, compute the rest of the company’s Piotroski F-Score. To gain a better understanding, try and check out its competitors in the industry as well. The firm’s Return on Assets should not be too far below the average of the industry.

Finally, once you have done all of this, further evaluate the company’s past and try to see how it would perform in the future.

While you undoubtedly be inaccurate to a certain degree, you will at least be far less inaccurate than someone who is uninformed of the company’s complete business model, financial strength, and business environment (including its role in the country, global and macroeconomic scale).

Only then do you begin looking to invest in the company.

Summary

Taken together, the PB Ratio and 9 point Piotroski F-score combined will remove personal bias and allow you to sift out only companies worth your consideration.

Having said that, please note that these two tests are not the end-all, be-all of how to analyse companies.

I provided these 2 tests in the hopes that it would at least provide a stable foundation upon which people can lean on when evaluating potential investment opportunities and to remove personal biases.

Additional factors you should consider AFTER they pass these the Price to Book Ratio Test tests are:

  1. Company Leadership/Management
  2. Durability of Competitive Advantages (What Warren Buffet calls a business moat. A protective advantage that a business inherently has due to some intrinsic factors of the business and / or business environment.)
  3. Risks to Sector due to Geo-political or Government policy
  4. Risk of trade war affecting business? (Shipping companies)
  5. Possibility of Fraud (we eliminate all China Companies from consideration for this reason)

If you have any questions, please feel free to comment below. I will do my best to answer all related questions.

PS: If you always had trouble finding stocks and knowing when to buy, sell and hold them, you will find our Factor-Based Investing Guide useful.

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Irving Soh

Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.
  • Nowadays it is hard to find low P/B companies in modern companies which requires lesser assets to create revenue compared to traditional industrial companies such as property, utilities, telco, manufacturing etc. Currently in SGX or US market, do we have a lot of companies that meet the 9 Pitrioski factors and P/B<1? Appreciate you can give a few examples. Thanks.

    • Hi ZhiGui, unfortunately, you will have to use a f-score screener provider. (https://fintel.io/screen/piotroski-score-screen). Currently, Ciner Resources (CINR) and Nucor (NUE) both are rated 9 points on the piotroski score, but both are above price to book value of one. The screener is also limited to american stocks so far, altho a representative im talking to says that support for that side shld be up this month.

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