Different Scores to Filter Companies

We can filter companies using various scores such as Piotroski F-score, Altman Z-score, Beneish M-score and Montier C-score. In this post, we will look into the scores to identify certain companies.

Piotroski F-score

F-score was developed by Joseph Piotroski. It is used to spot turnaround companies fast and also to identify the healthiest company among a basket of stocks. It involves nine variables from a company’s financial statements. In a research paper by Piotroski entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers“, it was shown that by investing in the top performers over a 20-year test period from 1976 through 1996 that “the mean return earned by a high book-to-market investor can be increased by at least 7.5% annually”. On top of that, he found that buying the top stocks in the market and shorting those that got the worst scores would have resulted in 23% annualized gains. Also, weak stocks, scoring two points or less, were five times more likely to either go bankrupt or delist due to financial problems.

There are nine variables in the F-score, split into three groups. Points are awarded in a simple binary fashion, 1 for yes, 0 for no. The variables are as follows:

A. Profitability Signals

1.     Net Income – Score 1 if there is positive net income in the current year.

2.     Operating Cash Flow – Score 1 if there is positive cashflow from operations in the current year.

3.     Return on Assets – Score 1 if the ROA is higher in the current period compared to  the previous year.

4.     Quality of Earnings – Score 1 if the cash flow from operations exceeds net income before extraordinary items.

B. Leverage, Liquidity and Source of Funds

5.     Decrease in leverage – Score 1 if there is a lower ratio of long-term debt to in the current period compared value in the previous year .

6.     Increase in liquidity – Score 1 if there is a higher current ratio this year compared to the previous year.

7.     Absence of Dilution – Score 1 if the Firm did not issue new shares/equity in the preceding year.

C. Operating Efficiency

8.     Score 1 if there is a higher gross margin compared to the previous year.

9.     Asset Turnover – Score 1 if there is a higher asset turnover ratio year on year (as a measure of productivity).

Altman Z-score

The Z-score is used to identify risky stocks. It was developed by Edward Altman. Any Z-score above 2.99 is considered to be a safe company and any companies with a score less than 1.8 is shown to have a significant risk of financial distress within two years. This formula can also predict bankruptcy of a company.

The original Z-score formula is as follows:

Z = 0.012T1 + 0.014T2 + 0.033T3 + 0.006T4 + 0.009T5.

T1 = Working Capital / Total Assets. Measures liquid assets in relation to the size of the company.

T2 = Retained Earnings / Total Assets. Measures profitability that reflects the company’s age and earning power.

T3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

T4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

T5 = Sales/ Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).

Beneish M-score

The M-score was developed by Messod D. Beneish and it helps to uncover companies that are manipulating its earnings. An M-score above 2.22 highlights companies that may be inflating their earnings artificially. This increases the probability that they will have to report lower earnings in the future. In his research paper entitled “The Detection of Earnings Manipulation“, Beneish has stated that the percentage of correctly classified manipulators ranges from 58 to 76%, while the percentage of incorrectly classified non-manipulators ranges from 7.6% to 17.5%. An interesting note is that students from Cornell University used the M-score to identify Enron as an earnings manipulator before its collapse.

M Score = -4.840 + 0.920 x DSRI + 0.528 x GMI + 0.404 x AQ + 0.892 x SGI + 0.115 x DEPI – 0.172 x SGAI – 0.327 x LVGI + 4.697 x TATA

Where:

Days Receivable Index (DSRI) is:
DSRI = (Net Receivablest / Salest) / Net Receivablest-1 / Salest-1)

Gross Margin Index (GMI) is:
GMI = [(Salest-1 – COGSt-1) / Salest-1] / [(Salest – COGSt) / Salest]

Asset Quality Index (AQI) is:
AQI = [1 – (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 – ((Current Assetst-1 + PP&Et-1 + Securitiest-1) / Total Assetst-1)]

Sales Growth Index (SGI) is:
SGI = Salest / Salest-1

Depreciation Index (DEPI) is:
DEPI = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))

SG&A Expense Index (SGAI) is:
SGAI = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)

Leverage index (LVGI) is:
LVGI = [(Current Liabilitiest + Total Long Term Debtt) / Total Assetst] / [(Current Liabilitiest-1 + Total Long Term Debtt-1) / Total Assetst-1]

Total Accruals to Total Assets (TATA) is:
TATA = (Income from Continuing Operationst – Cash Flows from Operationst) / Total Assetst

Montier C-score

The C-Score was developed by James Montier and is used to identify companies that cook the books and then short them in the process. It is almost similar to the M-score. A point system of 1 is given for yes and 0 for no. These scores are then summed up to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6 (all red flags are present). The areas tested are:

  1. Is there a growing divergence between net income and operating cash-flow?
  2. Are Days Sales Outstanding (DSO) increasing? This means that the “accounts receivable” are growing faster than sales and this may be a sign of channel stuffing.
  3. Are days sales of inventory (DSI) increasing? If so, this may suggest slowing sales. This certainly is a bearish sign.
  4. Are other current assets increasing vs revenues? The DSO and/or DSI are usually closely watched so some Chief Financial Officers may use this catch-all line item to help hide things
  5. Are there declines in depreciation relative to gross property plant and equipment? This protects firms altering their estimate of useful asset life to beat earnings estimates.
  6. Is total asset growth high? Some firms are serial acquirers and use their acquisitions to distort their earnings.

References:

http://www.stockopedia.co.uk/content/the-piotroski-f-score-a-fundamental-screen-for-value-stocks-55711/

http://en.wikipedia.org/wiki/Altman_Z-score

http://ycharts.com/glossary/terms/beneish_m_score

http://www.stockopedia.co.uk/content/montiers-c-score-are-your-favourite-stocks-cooking-the-books-63863/

Market Timing – Worthwhile?

Time and again, there has been a debate whether market timing works. Market timing is termed as predicting the future direction of the stock market by using technical charts and economic data.

There is one camp that believes that investors can move in and out of the stock market and by doing so, maximize their returns. They do this by using moving averages and support and resistance lines on the charts, amongst others. While this might work sometimes, at other times, these investors might miss the sudden gains that the stock market makes out of nowhere. This was the case in March 2009 where the stock market suddenly sprang off its lows and never looked back.

The other camp believes that market timing is futile predicting the direction of the stock market. There are numerous studies showing that being out of the market during only a few of the best days or months can ruin a portfolio’s long-term returns. Here are some of them:

  • Had you put $1,000 in the S&P 500 at the end of 1981, your stake would have grown to $25,584 (including reinvested dividends) by the end of 1998. But if you had missed the 30 best days (defined as the days with the highest percentage gain) of those 4,400 trading days, you would have ended up with $4,549, 82% less. (Source: Dow 100,000: Fact or Fiction.)
  • Consider three people who each invested $1,000 per year in the S&P 500 Index from 1965 to 1995. Investor A bought on the first day of each year, Investor B — the world’s best market timer — bought at the lowest price each year, and unlucky Investor C bought at the market’s peak each year. Here are the results:
  • Investor A (invests on first day of the year): 11.0%
  • Investor B (invests at market nadir each year): 11.7%
  • Investor C (invests at market peak each year): 10.6%
  • As you can see, the differences among the compound annual returns earned by each investor are small. (Source: Peter Lynch, Fidelity Investments brochure, “Key Things Every Investor Should Know.”)

Some of the astute minds of the investing world like Warren Buffett and Peter Lynch are certainly against market timing. Here are some quotes by them:

Warren Buffett –

  • “The only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
  • “We continue to make more money when snoring than when active.”

Peter Lynch –

  • “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”­
  • “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
  • “I don’t believe in predicting markets. I believe in buying great companies — especially companies that are undervalued and/or underappreciated…. Pick the right stocks and the market will take care of itself.”
I also read a research paper called “Black Swans and Market Timing: How Not To Generate Alpha” by Javier Estrada (right-click and “Save link as…”). In it, there’s ample evidence showing why market timing is pointless. I shall quote some information from there:
  • The evidence, based on more than 160,000 daily returns from 15 international equity markets, is clear: Outliers have a massive impact on long-term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent, in the average market, less than 0.1% of the days considered, the odds against successful market timing are staggering. Hence, of the countless strategies that academics and practitioners have devised to generate alpha, market timing does not seem to be the one most likely to succeed.
  • A very small number of days account for the bulk of returns delivered by equity markets. Investors do not obtain their long-term returns smoothly and steadily over time but largely as a result of booms and busts. Being invested on the good days and not invested on the bad days is key to long-term performance. But the odds of successfully predicting the days to be in and out of the markets are, unfortunately, close to negligible.

I feel market timing is not worth an investor’s effort as seen from the examples, researches and quotes above. I, too, have been guilty of market timing recently and I can strongly concur that market timing doesn’t work (at least for me)! I have learnt to just add on to my positions whenever there’s a significant dip in price. However, if my stock doesn’t move much, I will gladly hold on to my stock amid a financial meltdown and cash in on the dividends!

Investments risky? Saving in a bank is “riskier”

Last week, I was watching a drama show on TV and in a particular scene, the husband and wife were talking about investments. The husband said his friend is making $10,000 a month on top of his regular office hours job. He said his friend asked him to invest with him. The problem was that the capital needed would be $50,000. The husband said that the investment involves stocks. The husband suggested that he put in 50% of the capital and his wife, the other 50%. Upon hearing this and the insurmountable capital needed, the wife got astonished and was strongly against the idea of investing such a huge sum in stocks. She reasoned out that stocks are extremely risky, stocks are equivalent to gambling, she doesn’t have enough capital and she would not allow her husband to invest $50,000 in such a venture. The young couple has a pre-school daughter as well.

This whole scene perplexed me. What intrigued me the most was that the wife said stocks are risky and they are the same as gambling. Since they have a kid, they certainly have to finance for her needs as well. So, doing proper investment is one of the way to grow money.After the show was over, I asked my Mom how do the layman finance their personal needs, for example, for kids’ education, house, car, etc if they view investments as risky. My Mom replied that most do not really know how to invest and view investments as risky. They rather sock cash away in the bank as it’s “safer”.

My take on this whole drama scene is that saving money in a bank is actually “riskier” than doing prudent investments. By just saving money in a bank, inflation will be eating our money away. The average historical inflation is around 3% per year. Thus, our money is being eaten away at 3% yearly.

Warren Buffett once affirmed that risk comes from not knowing what you’re doing. Lack of knowledge promotes risk. So, since many do not know that $50k today is not worth $50k tomorrow, just saving money in a bank is “riskier”. We should educate ourselves by reading books on personal finance and look for alternative prudent investments that will allow our money to grow. Investments are certainly not risky if you know what you are doing.

What are your thoughts on this issue?

3 Essential Things for a Meaningful Kitty

Many of us want to retire comfortably, retire rich and retire without having to worry about money anymore. For a meaningful retirement, we must have a substantial amount of money to tide us through our retirement years. Even for short-term goals such as to finance a house, finance your child’s education or to finance a new care, we need to have enough moolah. For wealth accumulation to take place, three things are paramount. They are:

  • Investing as long as possible (time)
  • Amount invested and to be invested in the future ($)
  • Investing in instruments that give a substantial yield (returns on investment or ROI)

All three elements must be fulfilled before we can reach our financial goal. We will look at each element in detail below.

Time

The earlier we start investing, the better our returns can be due to the effect of compounding. Albert Einstein once said that compound interest in the eighth wonder of the world. Compounding allows our money to increase exponentially for the long-term. This can be seen from the graph below. By compounding, the graph shoots to infinity towards the later part of the investing timeline, although gains are minimal at the start. Thus, a young investor in his twenties will have more time to compound his money over a person in his forties who just starts investing.

Image courtesy of http://www.tvmcalcs.com/tvm/lumpsums_fv

Money

To start investing, we need capital. This can come from your savings mainly. As working adults, we should aim to save at least 10% of our monthly salary and we can slowly increase this percentage as our income increases. Without savings to start with, one cannot make more money by investing in the stock market.

Yield

Leaving money in the bank yields less than 1% in current market situations. Couple that with raging inflation that is around 5% currently, we are getting negative returns on our money. This makes the case for investing much stronger. The general stock market has yielded around 9-10% historically. By investing in fundamentally strong companies, your returns can be higher. However, don’t be cheated by claims cited by certain investment companies that can give u phenomenal 50% returns per annum. If it’s too good to be true, it probably is.

Below is a table with three different scenarios to illustrate my points above.

If you want to play around with the various figures to suit your financial life, you can visit the online “Compound Interest Calculator”.

To use the calculator,

1. Key in the current amount that you have currently invested under “Current Principal”. If you don’t have any money invested currently, type in “zero”.

2. Key in the amount you will invest yearly (take note: not monthly). For example, if you are going to invest $200 monthly, key in “2400”.

3. Key in the number of years you plan to invest.

4. Key in the yield of the instrument. You can key in 9% as that’s the historical stock market return.

5. Key in “1” in the next row.

6. Select “end of compounding period” in the following row and click “Calculate”. You can see the future value (how much you will have at the end of your investing period).

Happy compounding!

The Famous Marshmallow Experiment

The Stanford Marshmallow Experiment conducted in 1972 was a study on delayed gratification and is regarded as one of the most successful behavioural experiments. In the experiment, a marshmallow was offered to each child. If the child could resist eating the marshmallow, he was promised two the next round. Experimenters then analyzed how long each child resisted the temptation of eating the marshmallow and whether doing so had an effect on their future success. The experimenters followed each child into adolescence and adulthood.

The results were astonishing. The kids who could resist the temptation scored higher in tests, had stronger relationships and were promoted more often. They were also generally happier as adults. How is this experiment related to being financially independent? Delay gratification by not being tempted to buy the latest gadgets. Doing so allows one to save enough money to invest. By prudent investing, one can reap the benefits in the future. Time is an investor’s best friend so delaying gratification buys time and allows compounding to take place.

Golden Cross and Death Cross

I came across an article in this week’s The Edge magazine. The article touched on the technicals of the STI and I learnt about predication of long-term trends with the 50-day moving average and the 200-day moving average from the article.

When the 50-day moving average crosses above the 200-day moving average, a ‘golden cross’ is formed. This is a bullish signal for the long-term and the long-term trend is up.

However, when the 50-day moving average crosses below the 200-day moving average, a ‘death cross’ is formed. This is a bearish signal for the long-term and the long-term trend is down.

How can an investor use these signals? He can liquidate his positions when the death cross is formed and enter the market once again when the golden cross is formed.

I back-tested this strategy and I found that it’s quite reliably predicts the trend with extremely low occurrences of fakeouts. This can be seen from the chart below. A death cross was formed around early Jan 2008 and a golden cross was formed around mid-May 2009. Everyone knows it’s difficult to sell at a market top and buy at a market bottom. At least, with the signals, an investor could have cashed out before the market sell-off in 2008 and re-entered the market after the market bottomed in March 2009.