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How the Z-score can help your investment returns |
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It found that when buying companies based on undervalued multiples such as
price to book value ("PB") and price to earnings ("PE") ratios, in economic
downturns, returns are dependent on the balance sheet financial strength of
the company.
This makes intuitive sense and has been
especially important in the current downturn because of the
associated banking crisis.
Morgan Stanley used a measurement of
financial strength called the Altman
Z-score (“Z-score”). Which was developed in 1968 by
Edward I. Altman, an Assistant Professor of Finance at New York
University.
The Z-score is a combination of five
weighted business ratios and can also be used to predict bankruptcy.
In a series of tests covering three different time periods over 31
years (up until 1999), the model was found to be 80-90% accurate in
predicting bankruptcy one year prior to the event, with a error rate
of 15-20%.
The z-score is calculated as
follows:
Z-score = 1.2T1 + 1.4T2 + 3.3T3 + .6T4
+ .999T5.
T1 = Working Capital / Total Assets.
T2 = Retained Earnings / Total Assets.
T3 = Earnings Before Interest and Taxes
/ Total Assets.
T4 = Market Value of Equity / Book
Value of Total Liabilities.
T5 = Sales/ Total Assets.
And is interpreted as follows:
1.8 < Z-score < 2.99 = Middle or
grey
Z-score < 1.80 = Distress
Morgan Stanley ranked a basket of
companies by their Z-scores and found that when they compared
Z-scores with share price movements, companies with weaker balance
sheets underperformed the market more than two thirds of the time.
They also found that a company with a
Z-score of less than 1 tends to underperform the wider market by more
than 4 per cent over the year with a probability of 72 per cent.
‘‘Given the poor performance over
the last year by stocks with a low Altman Z-score, the results of our
backtest are now even more compelling than they were 12 months ago,”
argues Secker. “We calculate that the median stock with an Altman
Z-score of 1 or less has underperformed the wider market by 5-6 per
cent per annum between 1990 and 2008.”
When compound annual returns since 1991
were analysed, the results are more dramatic. On average, companies
with Z-scores of less than 1 saw their shares fall 4.4 per cent,
compared with an average rise of 1.3 per cent for their peers.
Even in years with strong economic growth such as the last 18
years stocks with a Z-score of 1 or less outperformed the market in
only five of the 18 years.
Here is the really unintuitive part of
the study.
What happened to companies that were in really good shape
financially?
Surprisingly during the bear market of
2000 to 2002, companies that had a Z-score greater than 3 fell almost
twice as much as the market.
This is quite baffling. I unfortunately
did not have access to the study to find a possible explanation.
The only thing I can think of is that
these companies may have been relatively overvalued when the study
was done as Morgan Stanley said they ranked a basket of companies by
Z-score. They unfortunately did not say what what was in the basket
to start off with i.e. low PE or PB companies.
So what is the short and sweet of the study:
The
clearest message from the study is avoid companies with a Z-score of
less than one unless you have a very good reason to buy.
I use the Z-score in my company
analysis as an early warning signal. Should the Z-score be less that
3 I investigate further.
Because I am relatively debt averse I
seldom find reason to have to investigate further.
Still on the topic of the Z-scores
U.S. companies with the worst finances
are beating the S&P 500 even as their funding deteriorates, a
sign their rally may falter should the economic recovery stall,
Armstrong Investment Managers said.
The weakest non-financial companies in
the S&P 500 surged 90 percent since March 9 through last week.
After the S&P 500 sank to a 12-year low five months ago, those
with the best finances gained 49 percent, data from Armstrong
Investment show. The companies were identified using New York
University Professor Edward Altman’s Z-Score method.
“When I analysed the stocks that have
lost me the most money, about two-thirds of the time it was due to
weak balance sheets. You have to have your eyes open to the fact that
if you are buying a company with a weak balance sheet and something
changes, then that’s when you are going to be most exposed as a
shareholder.”
Anthony Bolton has written a
new book called Investing Against the Tide. You can look at a review
of the book on the Interactive
Investor Blog. It is on my list of books to read.
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