Academic journal article Economics, Management and Financial Markets

Screening Stocks Based on the Rational Approach to Decision-Making

Academic journal article Economics, Management and Financial Markets

Screening Stocks Based on the Rational Approach to Decision-Making

Article excerpt

1.Introduction

Decisions to buy, hold or sell assets are not easy to make. Such decisions are sensitive to time horizon, portfolio allocation, diversifiable risk, un-diversifiable risk, and are based on asset "past," "present" performance of the entity behind the asset, and forecast about the "future" of the asset. How should one screen assets for inclusion in a portfolio? Which assets should be diagnosed (identified) as possible winners? Stock valuation to minimize diversifiable and undiversifiable risk depends, significantly, on information gathered through legal and illegal (i.e., inside information) means. Of course, if the market efficient hypothesis applies (which in its strong form states that stock prices completely reflect all available information, private or inside information as well as public) individual or institutional investors should not be able to speculate; any valuation effort would be nothing more than an exercise in futility. Although it has been demonstrated by various researchers that more established or more developed markets (e.g., US markets) function more efficiently than newly-established or developing markets (e.g., Myanmar), test results on market efficiency, especially when behavioral variables are considered, remain, to this day, inconclusive; see, among other, Chui at al. (2010), Kang et al. (2011), Nisar et al. (2012), Fama et al. (2012), Asness et al. (2013), Pyo et al. (2013), Jaggia et al. (2013), Huehn et al. (2014), and Jiang et al. (2016).

Various stock screening methodologies exist; by and large, they are based on variables ranging from quantitative (such as financial ratios) to qualitative (those associated with behavioral aspects). See Rosenberg (1993), Strong (2009), Fabozzi (1999), Sharpe et al. (1999), Barker (2001), Francis et al. (2002), Vause (2009), Arnold (2010), Jones (2010). Most prominent among these screening methodologies is the so-called "F-Score" by Piotroski (2000) and its many modified versions such as the one by Gray and Carlisle (2013) and Greenblatt (2010). Piotroski (2000) attempts to capture a stock's financial health based on 9 criteria (or signals) divided into 3 groups: profitability, financial leverage/liquidity, and operating efficiency. The F-Score is the sum of the nine binary signals; it measures the overall quality, or strength, of the stock's financial health which may help the invest or decide whether to include it in a portfolio. Piotroski computes its F-Score as follows:

(ProQuest: ... denotes formula omitted.)

where,

Profitability

ROA = return on assets (1 point if it is positive in the current year, 0 otherwise);

ΔROA = change in return on assets (1 point if ROA is higher in the current year compared to the previous one, 0 otherwise).

CFO = cash flow from operations (1 point if it is positive in the current year, 0 otherwise);

ACCRUALS = stock current year net income before extraordinary items less cash flow from operations, scaled by beginning of the year total assets. (The use of noncash accruals is a signal that can contain information about the composition and quality of a firm's earnings.) (1 point if CFO/Total Assets is higher than ROA in the current year, 0 otherwise).

Financial Leverage / Liquidity

ALEVER = historical change in the ratio of total long-term debt to average total assets. (It seeks to capture changes in the stock long-term debt levels; he views an increase in financial leverage as a negative signal, and vice versa). (1 point if the ratio is lower this year compared to the previous one, 0 otherwise);

ΔLIQUID = historical change in the stock current ratio between the prior and current year. (1 point if it is higher in the current year compared to the previous one, 0 otherwise);

EQISS = set to one if the stock did not issue common equity in the preceding year, and zero if otherwise.

Operating Efficiency

ΔMARGIN = stock current gross margin ratio (gross margin divided by total sales) less the prior year gross margin ratio (1 point if it is higher in the current year compared to the previous one, 0 otherwise);

ΔTURN = stock current year asset turnover ratio (total sales scaled by beginning of the year total assets) less prior year asset turnover ratio (1 point if it is higher in the current year compared to the previous one, 0 otherwise). …

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