After watching this video, you will understand how to implement Piotroski F-score in real life. All right, where are we now? We have understood basics of accounting, we have done a little bit of basics of markets, we have seen how to read a paper, structure of a paper, what part is important for us. We have seen how to pick up that algorithm part, how to understand where the data comes from and we also picked up this Piotroski paper and actually constructed Piotroski score. That's where we are right now. So we have F-score, which is Piotroski score ranging from one to nine. So quickly, it's time you can pause and think about construction of the score. So what are the profitability measures, capital structure measure and efficiency measures? So 4+3+2, which constitute Piotroski score, you can quickly recap. And now, you should be in a position, given a balance sheet, given a firm's details, you should be able to construct Piotroski score for all firms for which you have this data. Of course, you know what the data requirement is. So you need to have profitability information, leverage, you know, sales, so on and so forth. So that's where you are right now. So what do you do with this score? Go back to what we said in the abstract. So we said two things; we said a buy-and-hold strategy, which buys these stocks and holds - does approximately seven percent more than universe of high BM stocks. In other words, if you just buy all high BM stocks and hold on, if you make X percent; here, you'll do X plus seven percent. You would have done - I'm not saying you will do. You will do is not right, you may not be able to do, so that disclaimer always applies. Every - every sentence I say comes with that disclaimer. It's about past and likelihood of things working out in the future, not a certainty of things happening in the future. Coming back. So if you just buy and hold a stock or buy and hold this Piotroski portfolio of stocks, which scored very high - by the way, high Piotroski score means, fundamentally, relatively sound companies among these high BM stocks. Low score means, fundamentally, relatively not so strong companies. Now, if you buy this strong company then hold, you are likely to outperform the universe by seven percent. Now what's wrong with just buying and holding? Nothing wrong per se, but what is the - is there a possibility of you losing money if you just have buys? Yes. You know there is always a possibility of losing money in stocks, but when you - if you just do a buy, an old strategy, what if then that market goes down? Piotroski's claim is not that even if the market goes down, these stocks will make money. No, no. That is not the claim. Underline the word "outperform" - that's critical here. All that is saying is if the high BM universe owns X percent, this particular portfolio of high score, high F-score firms would have done X plus seven; so that X could be negative. What if the entire portfolio does minus 30 percent? Then what Piotroski shows is his portfolio does minus 23 percent. Can we do better? Yes. That's what Piotroski suggests. What we can do is that we can create a long short portfolio. What is this long short portfolio? Go back to our basics on markets module. Long is buying, short is selling without buying. So when you combine longs and shorts, that becomes a long short portfolio. Now, the question is what to long and what to short; or what to buy, what to sell. That's the basic question in trading, right? At the end of the day, the purpose of all this exercise is to come out with stocks to buy and stocks to sell. That's the goal. Now here - here is where your skill comes. There is no predetermined rule for this. So Piotroski also tries various combinations. So as a starting point, just think about this. A firm which is scoring nine out of nine, what is - what kind of firm is this? This is a firm with high return on assets. You should be able to tell all the nine by now. This is a firm which has a positive change in return on assets. This is a firm which has positive cash flows. This is a firm with low accruals. The firm actually has high operating performance, capital structure is fine. It has not raised equity in the recent past. Leverage is actually going down. Assets are not risk high and so on and so forth. So this - this - among this - and yet, the most important point to note, yet this - such a firm is falling in the category of high book-to-market firms. So if you go to the other half, which is low book-to-market firms, you will find any number of firms satisfying these - these nine characteristics. They are good firms; by definition, they are good firms. They satisfy these characteristics and the valuation is also high. So nothing surprising. You may not be able to - all these may be price in, so by buying them, you may not be able to make money. There is a separate strategy that deals with them; we'll talk about it later. But the point is, the firm that is scoring nine is a firm with all these good qualities; doing well on profitability front, doing well on operational performance front, doing well on capital structure front and yet finds itself in the universe of high book-to-market firms. That means market hasn't valued it positively or highly, although the fundamental performance looks decent. The more important thing, all those delta characteristics, you know, please pay some attention on the delta. What does delta characteristics mean? These metrics - you know, all these ROA or cash flow, they're all improving. That's what these characteristics are indicating. So these firms are not really having positive fundamentals; their fundamentals are turning for better. So definitely, firms scoring nine should be in your list of buys. Now that's easy. Now what about sell? Now, using the same argument, what are these firms which score zero? Think of a firm, you know, that is scoring zero on the Piotroski matrix. Well, this is a firm with extremely low profitability, they may be losing money; more importantly, profitability is declining, operating performance is declining and capital structure position is precarious. That is the reason why it gets a score of zero and it finds itself in high book-to-market firm category. Now here, market has identified the fundamentals of the firm correctly. Such a firm, which has such bad fundamentals, if you will, finding itself in this high book-to-market universe should not be surprised. Now it's - you can also think that - consider the dangers of investing in all high book-to-market firms. If you just pick the universe of all high book-to-market firms, you will also be picking up these stocks which are scoring zero on Poitroski scale - no, no, the score of zero in Poitroski scale itself doesn't mean anything. What it means is these are firms with bad fundamentals, declining fundamentals, declining operating performance, high chance of going bankrupt which - which are there, which are a part of high book-to-market universe. So it's important that you distinguish between these top quality and bottom quality firms. So as a starting point, what you can do is buy those stocks which score nine and sell those stocks which score zero. Now, is there a huge difference between nine and eight? Now, this is a qualitative judgement. What about firms which have eight? They are also good. You know, eight out of nine parameters, they have done well. It's possible that one of the parameters, it slipped because of some reason. So it's not a bad idea to actually include both nine and eight in your list of longs and similar on the same argument, the company which has scored one out of nine; it's possible that by luck, some - one of the factors, it has done well. So you can go short on that, zero and one. So another strategy could be go short on nine and eight and go long on zero and one. Now, where exactly to stop? Can we do seven, eight, nine, zero, one, two? Or can we do six, seven, eight, nine, zero, one, two, three, four? This is a judgment call and it crucially depends on the institutional set up in the country. So I would recommend that you start with the strictest definition, which is nine and zero and maybe go up to nine, eight and zero, one and see the results yourself and then think of changing and - changing your strategy. Because by doing so, you will be going long on high quality firms, going short on low quality firms. So why am I asking you to also consider eight? Because there may be very few firms at nine. Please remember this, this is - you're talking about high book-to-market universe. These are stocks valued very, very low. So unless we assume that investors, in general, misjudge a lot of stocks, it's unlikely that a lot of firms will get a score of nine. So you may not have enough stocks to trade. Remember this. These are - why are they valued low? These are firms with low analyst coverage, low liquidity, high chances of bankruptcy, as well. So analysts generally don't - don't follow them as much and that is why market has neglected them. So now coming back, pick up these nine, eight and zero, one firms and start trading. What do we mean by start trading? How do we trade? When do we trade? When do we buy? How long to hold? So that's what we'll analyze next.
