The Graham and Dodd system of value investing involves a margin of safety and a satisfactory return. But stocks of great companies have traded at lower valuations, and those same companies have subsequently gone out of business or filed for bankruptcy protection. The authors propose a hands-on valuation investment process that not only helps investors choose stocks of good companies but also rejected 100% of companies that became financially distressed during the study period.
What’s Inside?
Value investing involves investors buying good company stocks below their intrinsic value. In some cases, the margin of safety can become a weakness, and investors end up holding stocks of a company that never recovers before going out of business.
Blum (Journal of Accounting Research 1974) identified distressed firms with an accuracy rate of 94% for failure within one year and 70% for failure within three to five years. The authors devise an investment decision-making system to help investors better identify undervalued stocks and avoid companies that are susceptible to financial distress.
Of the 201 companies analyzed, the authors’ system selects 27 companies that are still in business and rejects all companies that are later proved to be in financial distress.
How Is This Research Useful to Practitioners?
Benjamin Graham introduced the concept of margin of safety, which is a discount offered in the form of a lower stock price compared with the intrinsic value. But investors often find themselves caught in a value trap, wherein they have purchased shares at a low price but then the company goes out of business. Thus, not every stock trading at low valuation is investment worthy.
The authors design a systematic way of avoiding this value trap: a heuristic that identifies undervalued stocks as well as companies that are susceptible to financial distress. The heuristic considers five key elements: prospects of continued probability, short-term financial health, long-term financial health, susceptibility to bankruptcy, and margin of safety in selection of value stocks.
Identifying a financially distressed company well in advance of its bankruptcy will help investors, creditors, and policymakers address risks associated with such events. The Blum method can identify companies that could fail within two years with an accuracy rate of 80%. To identify such companies, the authors’ heuristic relies on Piotroski’s F-score and Altman’s Z-score.
How Did the Authors Conduct This Research?
Compared with value investing that involves accounting and market modeling, the authors’ system is more convenient for practitioners. It predominantly relies on Piotroski’s F-score and Altman’s Z-score for its rejection of potentially financially distressed companies.
The authors build a list of bankrupt or financially distressed companies using Wikipedia and the Office of the Superintendent of Bankruptcy Canada. From these two sources, they compile a list of 79 publicly traded companies that are bankrupt or financially distressed and for which financial statements are available through Mergent Online for the past five years. Using Google Finance, they create another list of 151 companies with a price-to-earnings ratio of less than 15 and market capitalization greater than $500 million.
The final list, composed of 230 companies, is created by merging these two lists. Next, the authors mask the identity of these companies, including their names, year of operation, and so forth. Twenty-nine companies out of this list are discarded for not having complete financial statement information. The authors’ heuristic helps them develop a model portfolio of 27 companies. These 27 companies are still in business and have no signs of financial distress.