How to avoid bad investments
Investors tend to spend most of their time looking for assets that will appreciate in value over time. Yet according to loss aversion theory, most of us get a bigger kick out of side-stepping disaster than picking runaway successes.
We are not talking about share prices falling 15% or 20% as the market mood takes a downswing, as we have all witnessed during recent weeks. Those sort of events will burn the financial fingers of anyone who takes the widely received wisdom of staying invested for the long-haul.
Instead, we are talking about dodging the bullets fired by the likes of Carillion, Crawshaw (CRAW:AIM), Conviviality and Patisserie (CAKE:AIM) – all of whom ended up in administration and shareholders were wiped out, or they have recently experienced major financial problems.
But were these disasters, and many like them, really out of the blue? Perhaps not, according to academics who believe the warning signs are often there for those willing to read them.
If the boffins are right, how much would you be willing to pay for a predictive toolkit that could have flagged up Carillion long before it went to the wall in January 2018?
That sort of financial distress weapon could have been wielded to prevent losing thousands of pounds, getting you and other investors out long before the firm’s ultimate collapse, having alerted you to the soaring risk before the bottom fell out of the share price.
This is a job with which Altman Z-scores are supposed to be able to help. Later in this feature we’ll show you a handful of companies, large and small, potentially open to a financial bombshell.
A simple Z-score is a statistical measurement used to compare data points from different data sets to find correlations. Z-scores can be positive, negative or plain zero.
This concept was adapted to the business and finance world by Dr Edward Altman in the 1960s who used the metric to predict the likelihood that a company would go bust.
His calculation, now called the Altman Z-score, looks at several weighted financial ratios and compares them to a graded scale. The lower the score, the more likely the company is to declare bankruptcy.
Altman, a New York University professor, evaluated 66 companies where 50% of them had already filed for bankruptcy between 1946 and 1965. He analysed these companies using 22 ratios, which were classified into five categories: liquidity, solvency, leverage, profitability and activity.
Initially the Altman Z-score showed itself to be 72% accurate when it came to predicting that a company was going to the wall. But the accuracy improved with time.
Further studies over the subsequent decades (1969 to 1996) involved researching another 300 or so companies. The Altman Z-score got better, and better, first improving to 82% accuracy, then 94%.
Yet the applications for the Altman Z-score can help investors discover more about companies than whether or not they are facing collapse.
A study in 2009 by Graham Secker, a strategy analyst with investment bank Morgan Stanley, compared Altman Z-scores with the share prices of a basket of European stocks.
He discovered that companies with weaker balance sheets underperformed the market more than two thirds of the time. He also found that companies with an Altman Z-score of 0.99 or less were likely to underperform the wider market by more than 4% a year, with a probability of 72%.
ALTMAN Z-SCORE NUTS AND BOLTS
The calculation looks like this:
Z-score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
If you’re one of those people who were endlessly befuddled by mathematical conundrums (algebra, calculus?) back in your school days, stand easy as the equation looks more baffling than it is.
To fill in the relevant values all you’ll need is a set of readily available company accounts (the full year results or annual report will do), and the following recipe.
Each ratio gets a weighting to make it less or more influential to the Altman Z-score rating depending on the relevance as per professor Altman’s research. You add them together to get the final score.
You can find the scores on many well-known financial websites such as SharePad if you don’t want to calculate them yourself.
A = Working capital / total assets (multiple this figure by 1.2 for the Altman Z-score)
This ratio measures liquid assets. The companies in trouble will usually experience shrinking liquidity.
B = Retained profit / total assets (multiply by 1.4)
This ratio calculates the overall long-run profitability of the company. Dwindling profitability is a warning sign.
C = Trading profit / total assets (multiply by 3.3)
This ratio shows how productive a company is in generating earnings, relative to its size.
D = Market capitalisation / total liabilities (multiply by 0.6)
This ratio suggests how far the company’s assets can decline before it becomes technically insolvent (liabilities become higher than assets).
E = Revenue / total assets (no multiplication needed, 1:1)
This is the asset to turnover ratio and is a measure of how effectively the firm uses its assets to generate sales.
GOING BEYOND THE ALTMAN Z-ZONE
Altman’s original research has been used as the platform for further analysis over the years by other academics, such as Professor Richard Taffler. He is currently a finance professor at Warwick Business School and is a leading authority on behavioural finance and investment and has published over a hundred academic and professional papers and books.
Using decades of research he has developed his own Performance Analysis Score, or PAS for short, a system rooted in the Altman Z-score.
This is a financial analysis prediction machine designed to spot the financial fault lines buried within a company’s balance sheet that are all too often ignored by the wider investment community.
It is able to ping alerts when a company’s financial risk flashes red yet where the market has been slow to reflect this in the share price.
It claims to have flagged up rising risk levels in all 20 of the UK stock market bankruptcies since 2010. Another 32 companies that were eventually crushed under financial strain were also flagged by PAS.
Familiar names on this black list include Clinton Cards, Blacks Leisure, HMV, JJB Sports, Luminar and Snoozebox.
Perhaps its most striking red flag was at Carillion, which popped up on the PAS black list back in 2013, when its share price was riding high at more than 300p. The stock made steady progress lower right up until the company began its death throes in 2017.
GAIN AS WELL AS PAIN
PAS is also capable of highlighting names which may be in better shape than is suggested by their share price.
The system indicated earlier this year that Marks & Spencer’s (MKS) financials were quite sound, the opposite of what the market appears to be saying given its downwards share price performance over the past three years.
The PAS data also implied there is still life left in Mr Kipling baker Premier Foods (PFD) despite significant debt levels.
Taffler hopes to develop a range of tools for retail investors using the PAS system after teaming up with small cap investment advisory Equity Development.
NO SILVER BULLET
While PAS and the Altman Z-score have interesting applications for investors, it is also important to recognise the limitations.
For a start, a weak ranking does not necessarily mean a company is going bust. While it is difficult to imagine a corporate collapse that doesn’t show up with a weak Altman Z-score, plenty of companies have staged recoveries and escaped from the jaws of financial oblivion.
Another point worth noting is that the Altman Z-Score does not work very well for all companies.
The formula simply doesn’t stand up for the business model of most financial companies (banks, insurers, etc.). Utility firms also score poorly, skewed by low returns on assets and typically large debts, while ignoring enormous and stable cash flows, making them highly unlikely to get into too much distress.
The Altman Z-score also penalises young companies that haven’t been around long enough to build up lots of retained profit. New businesses do have higher bankruptcy rates but they can also be the source of huge profits for an investor if the company gets its growth and funding requirements right.
The Altman Z-score is not meant to be a stock selection tool in its own right; think of it as an extra thing to check when you’re running over companies that might have piqued your interest for various reasons. (SF)