Roadrunner Stocks focuses on small-cap value investing because academic studies have proven that small-cap value stocks outperform all other types of equity investments over the long run. Applying this academic research to one’s personal investment portfolio, however, has three caveats:

Value is defined by a snapshot ratio such as price-to-earnings or price-to-book value (lower the better) All stocks priced at or below the threshold value ratio (e.g., bottom 20%) are purchased The portfolio is rebalanced annually, with all stocks that no longer qualify as value being sold and replaced with newly-qualified stocks.

There are thousands of small-cap stocks and even isolating only the bottom 20% of small-cap names with the lowest price-to-book ratio results in several hundred stocks – far too many for the average investor’s portfolio.

Furthermore, many “cheap” stocks are cheap for a reason — their business prospects are in decline and getting worse. Other small-cap stocks are cheap because of investor neglect despite the fact that their financial fundamentals are solid and improving. The key to beating the market using small-cap value stocks in a practical manner requires some method for separating the simply-ignored winners from the deteriorating losers.

Improving the Odds of Success With Piotroski F-Score

In Buy Small-Cap Stocks Before They Grow Up, I introduced the 9-point Piotroski F-Score as one method for separating the winners from the losers. Piotroski’s thesis is that by screening for small-cap value stocks with improving financial fundamentals, you can avoid small-cap value stocks that face continued financial deterioration and price declines and isolate those small-cap stocks that have begun a turnaround and promise significant price gains. The F-Score is based on nine profitability, liquidity, and operating efficiency criteria to focus on those firms already showing year-over-year improvement and (hopefully) most likely to outperform in the coming one-year period. Sounds good, and the American Association of Individual Investors (AAII) reported that a stock screen based on the Piotroski F-Score was the only one of 56 screens tested that earned a positive return (up 32.6%) during 2008 when the S&P 500 lost 38% of its value. Such excellent back-tested performance is why the Piotroski F-Score is one of my six safety-rating components for Roadrunner Stocks.

But the AAII screen has limitations. Namely, it is based on a five-stock portfolio that is rebalanced monthly. Such a portfolio does not provide enough diversification and requires constant trading. In addition, Professor Piotroski’s conclusions are partly based on illiquid microcap stocks with a median market cap of less than $15 million – such stocks are typically so thinly-traded as to be uninvestable. Professor Piotroski warned that the 9-point F-Score was never intended as a “stand-alone” metric for choosing the best-performing small-cap stocks, but instead was intended only as an adjunct screen that helps weed out the worst-performing stocks. In other words, the Piotroski F-Score is best used as a safety filter rather than a stock-picking filter and it “does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms.” (page 6 n.2). Furthermore, the Piotroski strategy’s outperformance is based on pairs trading – buying both the stocks with the highest F-Scores (8 or 9) and shorting the stocks with the lowest F Scores (0 or 1). Most investors don’t short. Lastly, since the variation in performance of individual small-cap stocks is extremely large, the strategy requires that one buy and short all stocks with the high and low F-Scores, which means buying upwards of 100 stocks in each of the long and short portfolios per year, which is unwieldy for most investors.

Don’t Blindly Buy “Cheap” Stocks

Although the Piotroski F-Score screen is not a panacea for picking the best small-cap stocks, it goes a long way towards differentiating those “cheap” stocks that are promising investments from those that are value traps. “Cheapness” by itself is no way to find good investments. As my Investing Daily colleague Roger Conrad often says about dividend-stock investing, one should never chase the highest yielders, but focus on solid businesses that have the ability to sustain and grow dividends over time. Similarly in value investing, one should not chase the cheapest stocks but instead focus on those stocks showing the largest discrepancies between intrinsic value – based on discounted future free cash flows – and current market value.

Value is a relative thing, not an absolute measure. A stock with a price-to-earnings (PE) ratio of 20 can be a better value than a stock trading at a 5 PE ratio if the growth rate of the more “expensive” stock is high enough. As I wrote in Valuing Stocks Using the PEG Ratio, the PE ratio in isolation is meaningless because it only measures value in a snapshot of time without regard to future wealth generation potential:

If a dollar is a dollar is a dollar, why wouldn’t all companies have the same P/E ratio? When you buy a stock, you’re not just buying the earnings the company makes this year, but also the earnings it’s expected to make next year and the year after that. What if the earnings expectations for next year are $20 for Company A but only $10 for Company B? Wouldn’t you be willing to pay more for a dollar of Company A’s earnings this year if you expected to get much more in the following year? Of course you would. This is why P/E ratios are much higher for companies with high expected earnings growth rates than for companies with lower expectations. So before buying a stock, you need to look not only at its P/E ratio, but at its expected earnings growth rate as well.

The Piotroski strategy works because it goes beyond a stock’s current snapshot cheapness to look at the underlying business fundamentals and future potential. Those companies with improving fundamentals are more likely to generate larger cash flows in the future, whereas those with weak fundamentals are more likely to remain stagnant or suffer deteriorating future cash flows.

Although a Piotroski analytic overlay is an improvement over simply buying stocks with the lowest PE or price-to-book ratios, Piotroski only measures year-over-year improvement and does not model the company’s business prospects going out ten years as full-fledge discounted cash flow (DCF) analysis do. One-year improvements can easily reverse and are not reliable as long-term value measures; that’s why the Piotroski strategy requires annual or monthly rebalancing that incurs significant transaction costs.

Value Traps Come in Two Forms of Uncertainty: Current Asset and Future Cash Flow

A stock’s value has two components: (1) existing value based on current net assets (i.e., shareholder equity or book value); and (2) future value based on future discounted cash flows. For most companies, future cash flows are a much larger component of total value than existing net asset value, but for resource-heavy industry sectors such as mining, energy production, and finance, existing value is more important and, consequently, a snapshot value measure such as price-to-book-value can provide a good indication whether a stock is undervalued or not. But just as future cash flows are uncertain, so too can current value measures like book value. Examples include estimating how many barrels of oil an oil company actually possesses underground or estimating the credit-worthiness of a bank’s borrowers and what percentage of the bank’s loan assets will actually be paid back.

The 2008 financial crisis provided several examples of companies thought to be “cheap” based on book values exceeding their market capitalizations. Richard Pzena, a well-respected hedge fund manager and former director of equity research at Sanford C. Bernstein & Co., told the Value Investing Congress in November 2007 that home-mortgage securitizer Freddie Mac was “the cheapest stock he’d ever seen” and he followed up with a letter to Barron’s Magazine in March 2008 stating that both Freddie Mac and Fannie Mae were “extremely undervalued.” As it turned out, both stocks were extremely overvalued and lost 99% of their value by the end of 2008.

Similarly, between 2005 and 2008 hedge-fund manager Mark Sellers slowly put almost all of his investors’ money into natural-gas driller Contango Oil & Gas (NYSE: MCF), only to watch the stock lose 80% percent of its value by October 2008 as the price of natural gas plunged far below the $7 per Mcf level that Sellers thought was the long-term bottom. Investors in his fund redeemed their money en masse, and Sellers was forced to shut down his fund. To this day, 4 ½ years later, Contango’s stock remains more than 30% below its peak price in the $70’s that was reached in Seller’s purchase period during 2006 and 2007.

Freddie Mac and Contango Oil were both value traps that ensnared very smart investors who miscalculated the real value of their financial and natural gas assets, respectively, and interpreted their current stock prices as “undervalued.” This overestimation of asset values is why Benjamin Graham – the father of value investing – coined the phrase “margin of safety” and required a stock to be trading at no more than two-thirds of estimated net current asset value before he would purchase it (i.e., a 33% margin of safety).

Similar value traps exist in non-asset-heavy businesses that rely on growth in future cash flows for the majority of their value. In these cases, the “trap” is viewing the company’s current PE ratio as undervalued in relation to an overestimated ability of the company to grow earnings in the future. As stated above, for non-resource companies stock valuation and future earnings growth are inextricably entwined – to characterize value investing as having nothing to do with growth estimates is absurd.

Warren Buffett Does Not Distinguish Between Growth and Value

Warren Buffett is one of the strongest proponents of a value-investing definition based on “growth at a reasonable price” rather than Graham’s “current net asset value at a 33% discounted price”. Buffett explained his value philosophy in Berkshire Hathaway’s (NYSE: BRK-A) (NYSE: BRK-B) 1992 shareholder letter:

We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price. But how, you will ask, does one decide what’s “attractive”? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase. A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.” Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future “coupons.” At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

A company’s value is determined by discounted future cash flows – regardless of whether those cash flows are destined to grow or shrink. Consequently, even a dying business estimated to experience negative growth over the next decade (e.g., apparel brand-name licensor Cherokee) can be “undervalued” if the current market price falls below these shrinking future discounted cash flows. In his 1989 shareholder letter, Buffett called such companies “cigar butts” that give investors one last puff of pleasure on their way to expiring, but he doesn’t recommend focusing on such companies because it is very difficult to estimate an accurate rate of business decline. If you underestimate the rate of decline, your intrinsic value estimate will turn out to be too high and you’ll lose money on the investment. It’s better to focus on “wonderful” businesses with quality management because they are more likely to offer up positive surprises, whereas cigar butts are more likely to suffer negative surprises.

Avoiding Value Traps is the Key to Investment Success

Performing a full-fledge discounted cash flow (DCF) analysis is not only time consuming, but requires an endless number of input assumptions that are likely to turn out to be wrong. Consequently, the key to successful value investing often revolves around avoiding big losses from value traps rather than finding the few severely undervalued hidden gems. As Buffett said in his 1992 shareholder letter:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Avoiding big investing mistakes does not require a DCF analysis – rather, it requires a few qualitative “rules of thumb” to identify value traps. Value traps are nothing more than companies whose businesses exhibit a high degree of uncertainty in asset values or future cash flows. Avoiding businesses with high uncertainty will largely eliminate the risk that you will overestimate a stock’s intrinsic value and overpay.

Short-seller Jim Chanos of Kynikos Associates has made presentations at both the October 2011 and June 2012 Value Investing Congresses where he presents his criteria and candidates for value traps:

Looking at all these value-trap criteria, the bottom line is that large-cap “cheap’ stocks are often cheap for a reason and aren’t really values at all. Only small-cap “cheap” stocks – because of investor neglect – have a good chance of being undervalued opportunities.

To quote again from Warren Buffett 1989 shareholder letter, don’t be hypnotized by “bargain-purchase folly:”

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Good jockeys will do well on good horses, but not on broken-down nags. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.

Avoiding Uncertainty is Worth Paying a Higher Price

Even for wonderful companies, value still plays a role as Buffett only buys them if they are trading at a “fair” price. The key point is that really cheap prices are usually associated with troubled businesses and the difficulty in turning around such businesses is not worth the super-cheap price. The best way to avoid value traps is to seek out what Buffett calls “inevitables” – companies with insurmountable competitive advantages that make it inconceivable that their business will not thrive in the future:

Companies such as Coca-Cola and Gillette might well be labeled “The Inevitables.” Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer – not even these companies’ most vigorous competitors, assuming they are assessing the matter honestly – questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade. Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them. To the Inevitables in our portfolio, therefore, we add a few “Highly Probables.”

Small-cap companies have not yet reached the critical mass necessary to enjoy “inevitable” status, so my goal in Roadrunner Stocks is to find reasonably-priced “highly probables,” while avoiding the far-more numerous value traps.

In the next monthly edition of Roadrunner Stocks, I’ll explore the positive attributes that most “highly probable” outperforming small-cap stocks possess, and which comprise a large part of my research in choosing Roadrunner recommendations.