Academic research is an often-overlooked treasure trove of information for investors. Some investors ignore the research journals because they know the academic community believes markets are efficient and since academics believe that, some investors reason that there can’t be anything about how to beat markets in the journals. This is not true.
Academics do tend to believe the efficient market hypothesis (EMH). In broad terms, this idea says market participants, as a group, immediately analyze new information about companies as it becomes available and then efficiently push the price of the stock to its proper level. This theory explains why we often see gaps develop the day after an earnings report.
For example, Netflix (Nasdaq: NFLX) recently announced earnings and told analysts that subscriptions had grown faster than expected. This represented new information and needed to be incorporated into the stock price. The stock immediately jumped almost 19% as traders assessed that new information. This is the kind of behavior easily explained by the EMH – new information led to an immediate revaluation of the stock.
But not all stocks behave this way. Sometimes stock prices drift up or down in long-term trends. At first, this might sound like proof the EMH doesn’t work but researchers instead found that this behavior is explained as an anomaly to the EMH. In the long run, stocks do show trends that can be explained as the momentum anomaly to the EMH.
All this research is relatively well known and even though it’s well known, the principles uncovered by researchers can still help investors earn large returns. But, of course, there are more obscure areas of research and these less well-known ideas could add even more value to a portfolio.
A popular area of research is on how to avoid losing money. It may sound obvious but one of the best ways to increase wealth is to avoid large losses. This has been widely studied and the amount of damage a single large loss can have on a portfolio is well understood. Despite that, many investors still hold stocks that decline by 50% or more. To minimize this risk, some researchers have looked for ways to identify stocks that are likely to suffer losses.
It’s interesting that this is an area researchers have spent a great deal of time studying and at the same time is an area a large number of individual investors have ignored. We know most investors fail to earn large fortunes so it could be useful to do something most investors fail to do.
Researchers often develop indicators, tools, for example, like the popular stochastics indicator individual investors use. But indicators built by researchers are much more sophisticated than that. Among the tools fundamental analysts use are the Z-score, an indicator developed to specifically identify how likely a company is to go bankrupt. This indicator was developed by Dr. Edward Altman, a professor at the New York University Stern School of Business, one of the most prestigious business schools in the country.
Professor Altman first published his research in the 1960s and decades of experience have demonstrated the value of the indicator. To be perfectly honest, the math can be daunting. The Altman Z-Score consists of five different fundamental ratios that are combined into a single score. The five individual ratios are weighted using a formula Altman found using regression techniques. You won’t have to know it but the formula is:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = working capital ÷ total assets
B = retained earnings ÷ total assets
C = earnings before interest & taxes ÷ total assets
D = market value of equity ÷ total liabilities
E = sales ÷ total assets
This formula brilliantly combines information from the income statement, the balance sheet and the statement of cash flows into a single indicator. To analyze the Z-Score of a company, Altman established a scale based on the relationship that the lower the value, the higher the odds that the company is headed toward bankruptcy and came up with the following rules for interpreting a firm’s Z-Score:
- Below 1.8 indicates a firm is headed for bankruptcy;
- Above 3.0 indicates a firm is unlikely to enter bankruptcy; and
- Between 1.8 and 3.0 is a statistical “gray area.”
One advantage of using academic research is that there are almost always statistical reports telling us how well the idea works. In this case, Altman’s initial tests showed the Z-Score was accurate 72% of the time when it came to predicting bankruptcy two years prior to the event. In subsequent tests, using more than 30 years of data in an independent test, the indicator was found to be more than 80% accurate in predicting bankruptcy one year prior to the event. Not all companies with low Z-scores go bankrupt but many do.
Even though individual investors tend to ignore arcane academic research, Wall Street often pays attention. Analysts at Morgan Stanley studied the Z-score from the perspective of an investor. Their research showed companies with weak balance sheets underperformed the market more than two-thirds of the time. Importantly, they found a company with a low Altman Z-score tended to underperform the wider market by more than 4%.
In other words, the Altman Z-score can help investors improve performance by avoiding stocks that are likely to underperform the market. This is a problem many individual investors never even think about, even now as concerns of a bear market are mounting.
There are a few practical ways to apply this research right now. You could simply avoid buying the stocks with low Z-scores and are likely to underperform the market in the next year. You could also sell stocks like this if you own them. Or, you can buy put options on stocks with low Z-scores.
To find stocks suitable for this strategy, we scanned the companies in the S&P 500. These are big name companies that are at risk of bankruptcy. Even if they avoid bankruptcy, the stocks of these companies are likely to lag the S&P 500 and they should be avoided by investors looking to beat the market.
Five likely laggards are:
- Nordstrom Inc. (NYSE: JWN) has a significant amount of debt relative to its peers. The company also turns over its inventory less often than its peers, another sign that the company faces financial stress if the economy slows.
- H&R Block, Inc. (NYSE: HRB) also faces a significant amount of debt and cash flow has been contracting over the past few years. Without an increase in cash flow, it can be difficult for a company to grow.
- Mylan N.V. (NYSE: MYL) faces political pressures over price increases associated with its Epipen products. Even before that problem was known, the financial statements were warning investors away from this stock.
- AutoNation, Inc. (NYSE: AN) has seen its inventory increase faster than sales over the past year and its short-term liabilities are significantly greater than its short-term assets. Auto sales seems to be slowing and a cash crunch is possible if sales slow more.
- Legg Mason, Inc. (NYSE: LM) is a regional brokerage firm that could face stress in a bear market. The company already has a high debt load and could violate its debt covenants if cash flow decreases further.
Each of these companies is a sell based on the Altman Z-Score and interestingly each of these companies also faces a unique risk that should concern investors. These are five stocks that should be avoided. Aggressive investors could buy put options on these stocks to benefit from a possible decline because they are likely to be among the biggest losers in a possible bear market. And, if you own any of these companies you could consider selling them because they are likely to underperform the market over the next year.