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On the scale of disasters that can befall investors, being left holding shares in a company that goes bankrupt is one of the most gut wrenching.
Regulators and market operators generally hold quoted companies to high standards. They have to abide by well-documented codes of financial reporting and governance. But there’s no escaping the fact that some do occasionally collapse - sometimes with very little warning.
Rules and outcomes of bankruptcy arrangements differ from country to country. But for regular equity holders, the losses are typically painful and permanent. They’re usually at the back of the queue when administrators are shaking whatever value is left from the remains of a broken business. That can mean the value of your investment literally ‘going to zero’.
Bankruptcies are generally infrequent, but when they do happen it can be for a host of often-connected reasons. Dramatic changes in economic conditions, industry dynamics or aggressive competitors are all classic reasons. But so too are poor management, weak strategy, faulty business models, bad capital allocation and excessive debt.
Good investment research usually explores all the things that might go wrong with a company - as well as all the things that might go right. But the human bias for optimism means that it’s easy to explain-away nagging warning signs.
Given that bankruptcies can seemingly come out of nowhere - and be caused by any number of reasons - what can you do to try and see the red flags before they end up losing you money?
An answer to this question lies in the work of a finance academic called Edward Altman, who first examined it back in the late 1960s. In fact, his work was among the first properly scientific studies of what makes firms go bust since America’s Great Depression in the mid 1930s. It was only at that time that the data and computing power was available to undertake it.
Despite the fact this research dates back more than 50 years, it’s still regarded as one of the most insightful checklists of its type - and Altman remains an influential figure. It’s still very much in use in investment strategies deployed by investment banks and fund managers to identify weak (and strong) balance sheets.
Professor Altman devised what’s called the Z-Score. It’s a series of five accounts-based tests that are each weighted differently. The idea is that a company is checked against each test and then given an overall score. Here are the tests:
The overall score involves summing the ratios based on the following weightings:
1.2×T1 + 1.4×T2 + 3.3×T3 + 0.6×T4 + 1.0×T5.
This original Z-Score was conceived by Professor Altman based on his study of manufacturing companies. Stockopedia applies a variation of the score (Z2 Score) for non-manufacturing companies, which removes the fifth test (Sales / Total Assets) and weights the remaining tests like this: 6.56×T1 + 3.26×T2 + 6.72×T3 + 1.05×T4. It’s also important to note that the Z-Score is not designed for use with financial companies.
Importantly, the Z-Score doesn’t aim to predict when a firm will actually go bankrupt. Instead, it’s designed to help understand the extent to which a company resembles other companies that have failed in the past.
In Professor Altman’s research he effectively created three zones: Safe, Gray, and Distress. There is some evidence that different market conditions can blur where the cut-offs for each zone should be. But nonetheless, the framework remains solid:
In Altman’s research, the Z-Score was accurate 72% of the time in detecting bankruptcy two years ahead. It had a false positive rate of 6%. What’s remarkable about this is that the original study was only based on a sample of 66 companies, half of which had filed for bankruptcy - and yet the model has stood the test of time.
By its nature, it’s easy to see how the Z-Score might be used as the basis of a long/short investing strategy based on finding stocks with either strong or weak balance sheets. But for regular investing - and this is supported by Altman’s own views - there’s perhaps more utility in it being a checklist to avoid problems (or at least understand where there might be potential issues worth closer investigation).
On Stockopedia StockReports, you can find Z1- and Z2-Scores in the Quality area, under Bankruptcy Risk:
The Z-Score is also available as a standalone Guru Screen: Altman Z-Score short selling, as well as being an additional checklist in the James Montier Trinity of Risk short selling screen and the SocGen-inspired Quality Income dividend screen.
You can also integrate the Z-Score into any custom screen in the Screener. To do this, open a new screen (or an existing one) and select “Add Rule”. You can find the Z-Scores under “Quality” > “Solvency”. Here’s an example of how it can be used in a screen:
You can use this screen as a starting point.
All Stockopedia screens can also be viewed as checklists (accessible via the Tools menu on StockReports). This allows you to see which rules in you screen a stock passes and fails:
While no checklist provides complete protection from unpredictable difficulties and disasters, the Z-Score is one of just a few tools that are designed to look for problems before they lose you money.
While the model can pick up false-positives, and the ‘zones’ may not be accurate all of the time, the Z-Score still offers a useful look at how a stock rates against tell-tale signs of concern. Its continued use in professional financial settings is an acknowledgment that Altman’s original findings still hold true.
About Ben Hobson
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If you want to go deeper, there's an academic discussion on Stocko by someone who studied the Z-Score as part of their dissertation here.
Part of the conclusion: "If you want to focus on avoiding companies which might become bankrupt, any company which has a good Z-Score is likely to be safe. But a company with a poor Z-Score probably won’t go bust either!"
The Z score is a child of its time, when security was the focus - not the focus (or relevant?) now.
Note there is no calculation of profit / cash flow to debt - an income based cover calculation.
Not totally irrelevant but not critical IMV.
So it doesn't surprise me that Epsilon found so many companies which fall foul.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Excluding Financials, there are currently 320 UK companies which have an Altman Z Score below 1.8 (Altman Z for manufacturing or Altman Z2 for non manufacturing companies).
Currently 20 names in the list score very highly regarding the StockRank.
Are 20% of UK listed companies really facing a high probability of bankruptcy? It would surely take a severe/elongated recession to generate this outcome?