How the Z-score can help your investment returns

//How the Z-score can help your investment returns

How the Z-score can help your investment returns

 

I recently came across an interesting article in the Financial Times called New study re-writes the A-Z of value investing based on thought provoking research from the investment bank Morgan Stanley.

They found that when buying undervalued companies based on valuation measures such as price to book value (“PB”) and price to earnings (“PE”) ratios, in economic downturns, returns are very dependent on the balance sheet financial strength of the company.

This makes intuitive sense and has been especially important in the 2008 and 2009 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:

Z-score > 2.99 = Safe

1.8 < Z-score < 2.99 = Middle or grey

Z-score < 1.80 = Distress

Source:Wikipedia

 

Basket approach

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 under-perform 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 back-test 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.

Only five of the 18 years did companies with a Z-score of 1 or less outperform the market in and this took place only in years with strong economic growth.

 

Not intuitive

Here is the really un-intuitive 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 more than the market.

This is quite baffling.

The only thing I can think of is that these companies were internet companies that had strong balance sheets but were completely overvalued.  In the study Morgan Stanley ranked companies only by Z-score and not by valuation.

So what is the short and sweet of the study – how the Z-Score can help your investment returns

The clear 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.

 

More on the z-Score

Still on the topic of the Z-scores

Similar to my article Invest in over leveraged junk at your peril in August 2009 Bloomberg mentioned the results of a study by Armstrong Investment Managers which found that:

 

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.

 

Ignore balance sheet strength at your peril as well regarded fund manager Anthony Bolton has said:

“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.”

 

By the way

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.

 

Your looking at the Z-score analyst

 

Tim_sign3

 

 

By | 2017-05-19T15:11:09+00:00 September 10th, 2009|Tags: , , , |