Good & Clean 3.0: Battleships ::Ambit research

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Good & Clean 3.0: Battleships
Against the backdrop of Europe’s impossible fiscal position and the
Indian economy’s marked deceleration, investors need to focus on
“battleship stocks” with strong balance sheets, strong operating cash
flows and clear competitive advantages. Given the adverse economic
situation, rather than relying upon traditional notions of “defensive”
sectors, we use Piotroski’s F-Score to identify battleships. We therefore
retire our Good & Clean (G&C) 2.0 portfolio and introduce G&C 3.0:
Battleships. The first two G&C portfolios have outperformed the
BSE200 by 12.7% since inception in mid-March.
A world in tatters
Over the past week, our research has highlighted that Europe’s fiscal position
is beyond repair (and hence requires large scale sovereign default) and the
sustained deceleration in Indian economic growth. While our previous
research has shown the impossibility of rescuing Europe, the persistence of a
‘near-crisis’ environment in the West led us on 17th October to cut our FY13
GDP growth for India to 6.2% (from 7.2%). With this marked deterioration in
economic conditions, it becomes imperative to focus on battleship stocks
which pass a battery of financial tests (rather than simply relying upon
traditional notions of “defensive” sectors).
Piotroski’s F-Score
Piotroski’s F-Score is a quantification of a firm's financial health through the
use of 9 financial statement based parameters which fall into three categories:
 Profitability: positive RoA, Increasing RoA (YOY), positive CFO, CFO
greater than PAT;
 Capital structure changes and debt servicing ability: declining
debt:equity (YOY), improving current ratio (YOY); and
 Operating efficiency: improving operating margin (YOY), improving
asset turnover (YOY).
Joseph Piotroski, in his 2002 paper ‘Value Investing - The use of historical
financial statement information to separate winners from losers,’ showed that
these measures of financial health taken together are a powerful source of
investment returns.
Applying the F-Score to the Indian market
We applied the F-Score to the BSE500 over FY06-FY11. Firms with an F-Score
of “8 out of 8” (around 16 stocks/year) outperformed the BSE500 on an equal
weighted basis by 17% on a CAGR basis while outperforming on a market
cap weighted basis by 12% CAGR. Similarly, firms with an F-Score of “7 or
better” (around 68 stocks/year) outperformed the BSE500 equal weighted
universe by 9% CAGR while outperforming on a market cap weighted basis by
18% CAGR. Strikingly, applying a further valuation screen (say, P/B) to these FScore
driven portfolios did not meaningfully improve investment performance.
Good & Clean 3.0
Since the “7 or better” portfolio gives us comparable investment performance
to the “8 out of 8” portfolio, we apply the “7 or better” F-Score on the BSE500
universe to arrive at the final list of potential portfolio stocks. We then run
these stocks through our forensic accounting model to weed out suspect
names. This then gives us the final set of 36 stocks which constitute G&C 3.0
(see Exhibit A). In parallel, we retire G&C 2.0. The first two versions of G&C
(versions 1 & 2 were launched on 17th March and 22nd June respectively) have
outperformed the BSE200 by 12.7% since mid-March.
We have arranged our battleships into two buckets based on 3 month ADV as we
appreciate that a number of our clients face ADV based restrictions in their
portfolios. While Piotroski’s original paper talks about the performance superiority
of smaller caps, we reiterate that our backtesting results show that F-score based
portfolios consistently outperform market benchmarks on a market cap weighted
basis (and not just on a equal weighted basis).
Finally, from the list of “battleship” stocks highlighted by our Research team in the
Economy note dated 17th October 2010 - Voltas, Torrent Power, ONGC, Oberoi
Realty, Pidilite, Exide, Amara Raja, Navneet Publications - only two stocks – ONGC
and Pidilite- pass the battery of financial tests used in this note. Here is why the
rest of the stocks fail the F-Score criterion:
 Voltas: fails 4 of the 8 tests namely CFO greater than PAT, increasing RoA
(YoY), declining D/E (YoY), improving profit margin;
 Torrent Power: fails 2 of the 8 tests namely improving current ratio,
improving asset turnover;
 Oberoi Realty: fails 3 of the 8 tests namely CFO greater than PAT, increasing
RoA (YoY), improving asset turnover;
 Exide: fails 2 of the 8 tests namely CFO greater than PAT, improving profit
margin;
 Amara Raja: fails 3 of the 8 tests namely CFO greater than PAT, increasing
RoA (YoY), improving profit margin;
 Navneet Publications: fails 3 of the 8 tests namely CFO greater than PAT,
increasing RoA (YoY), improving asset turnover.
We will soon be displaying our F-scores screen on our website so that clients can
open our battleships model and play with the F-score and the P/B parameters.