Warren Buffett’s rule #1 of investing is “Don’t Lose Moneyquot; while rule #2 is “Don’t forget rule #1.” As with most Buffet aphorisms, though, the devil is in the detail of implementation. Clearly, though, one important way to prevent yourself losing money is to avoid investing in fraudulent or financial weak companies. While forensic accounting and detailed credit analysis may be beyond the ability of most individual investors, there are some excellent statistical short cuts that have been developed by professors of finance to highlight high-risk shares. Our research and reading in the area have uncovered the following 3 investing red flags that we think every sensible investor should try to understand in the context of their stock portfolio.
What's the Bankruptcy risk?
The Altman Z-Score has been a part of the investor toolkit for more than 40 years but is not as well-known as it should be. It was developed by New York University finance professor, Edward I. Altman, who used a combination offive weighted business ratios to estimate the likelihood of financial distress. It was initially created to test the financial health of manufacturing companies; with later tweaks opening it up to non-manufacturing and even private companies. Ultimately, any Z-Score above 2.99 is considered to be a safe company. Companies with a Z-Score lt; 1.8 have been shown to have at significant risk of financial distress within 2 years. Some investors may question the idea of using a formula to predict bankruptcy – and to be fair it does produce some surprising results – but nevertheless tests have proved it to be highly effective. Its initial test found that it was 72% accurate in predicting bankruptcy two years prior to the event, while subsequent examination has shown 80-90% accuracy.
What's the Earnings Manipulation Risk?
Glamour and growth are alluring not only to investors but also to company management whose compensation is dependent on a continuation of the trend. Accounting tricks such as booking sales early, changing depreciation rates and so on are all available for managers to massage earnings figure. The Beneish M-Score was developed to highlight these companies. An M-Score gt; 2.22 highlights companies that may be inflating their earnings artificially increasing the likelihood they will have to report lower earnings in the future.
In a similar vein, James Montier has developed a system called the C-Score which looks for similar tell-tale signs that management may be cooking the books.
What's the Financial Health trend?
The now very renowned Josef Piotroski came up with his 9 point scoring system in order to figure out which of the cheapest companies in the market were most likely to recover. The so called F-Score spans nine tests of changes in profitability, efficiency and leverage from year to year which highlight improving or declining financial health trends. This can be used both to identify financially solid companies (i.e. F-Score of 8 or 9) or to weed out (and/or short) financially frail ones (James Montier and others have found that glamour stocks with F-Scores lt; 3 and poor capital discipline make good short sale candidates).
Ok but how do I calculate them?
Want to know the scores for your portfolio of stocks? They're unfortunately pretty involved to calculate manually but we've now integrated all three of these indicators into the Stockopedia PRO stock reports, in order to give greater visibility about the financial health of your portfolio. As with any statistical measure, they aren't always a sure bet on their own BUT the idea is that they may flag something you've missed and prompt further investigation - which might just save your bacon!
And one more for good measure...
Another statistical measure that we've not yet modelled - but we have plans to add as it looks very effective - is the O-Score. This assesses the risk of an inflated valuation by looking at the following 5 factors:
- High likelihood of earnings overstatement (based on the Beneish score above)
- Unrealistic market expectations, judged by a high price to sales ratio
- Poor current operating cash flow
- A history of merger activity
- Recent / excessive issuances of stock.
If that rings a bell for your portfolio, take care! Firms with O-Scores equal to five were also shown to be nearly five times as likely to restate the current period’s earnings at some future date...