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A short and simple summary: Financially strong companies have outperformed the market for decades, and continue to do so. This is empirically proven and robust. By financially strong we mean profitable companies with positive cash flow, revenue growth, low debt and many more indicators. In a way this makes sense as you are ultimately buying a share in the company. And it wouldn’t be too surprising that “good” companies perform better than “bad” companies; right?
Here is the more boring, longer version:
Piotroski (2000) has shown that an investment strategy applied to companies exhibiting traits of financial strength consistently outperforms the market. Piotroski proceeded to compose a so-called F-Score, which ultimately differentiates between financially strong and weak companies, allowing for excess returns. We believe that this is an empirically proven and robust strategy that will allow investors to consistently earn above-market returns in the long term.
Henceforth, the stock bundle presented under this investment ideology uses the findings of Piotroski while adding certain selection criteria that further differentiates between winners and losers. In detail, stocks must have an F-Score of 8 or above, positive free cash flow (FCF), a return on invested capital (ROIC) that lies above 10% as well as positive revenue growth over the last 5 years.
Free cash flow will be added as a selection criteria for financially strong companies as it accounts for capital expenditures of a company. This allows accounting for the expenses incurred by a company to avoid bankruptcy and to further uphold its financial position. When using operating cash flow, essential expenditures such as the maintenance or acquisition of fixed assets are not accounted for, which could prevent a true reflection of the financial strength of a company, especially when it is capital intensive and relies on machinery.
ROIC outweighs traditional measures of profitability such as return on assets as a signal for financial strength in a way that it excludes non-operating assets. Companies with a large amount of non-operating assets can have strongly downward biased return on assets since non-operating assets do not produce high rates of returns. Hence, including them in the evaluation of financial strength of a company will understate the ability of the company to produce actual returns from its operating assets. Additional advantages are that ROIC takes into account how much investment a company requires to generate returns. Other measures of financial performance often disregard this important factor and overstate companies that in fact require high levels of investments to maintain their financial position. As ROIC is derived by dividing operating profits over invested capital, where operating profit is the difference between price and cost per unit sold, a superior ROIC results from competitive advantage over peers in terms of price leadership, cost structure or a more efficient use of capital, all of which are fundamental signals of financial strength.
Last but not least, maybe a little comfort and support: TCI Management is a hedge fund that uses a very similar approach and has been a top performer in recent years.