We aim to use Altman’s Z-Score model to create the Valuehuntr Short-Only Portfolio and track the effectiveness of Altman’s regression.
The Z-Score is a predictive model created by Edward Altman in the 1960s while serving as an Assistant Professor at NYU. The model combines five different financial ratios to determine the likelihood of bankruptcy amongst companies. In general, these financial ratios are used to predict corporate defaults or financial distress status of companies.
The model’s regression is as follows:
Z –Score = 1.2*A+1.4*B+3.3*C+0.6*D+0.999*E
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = EBIT/Total Assets
D = Market Value of Equity/Total Assets
E = Sales/Total Assets
According to Altman, companies with Z-Scores above 3 are considered to be healthy and, therefore, unlikely to enter bankruptcy. Scores in between 1.8 and 3 lie in a gray area. Scores of 1.8 or less indicate a very high probability of insolvency. This is because each of the variables, A to E, was found to be significantly different among bankrupt and non-bankrupt groups in the original study.
In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event. In a series of subsequent tests covering three different time periods over the next 31 years (up until 1999), the model was found to be approximately 80-90% accurate in predicting bankruptcy one year prior to the event. Althought the model has performed well over the years, it is important to keep in mind that it is only a statistical regression. In fact, plenty of businesses with dangerously low Z-scores have come back from the brink, producing extremely attractive performance. Therefore, investors should not rely solely on this model to find investment opportunities.
ValueHuntr Short-Only Portfolio
Our short-only portfolio consists of companies with Z-scores less than 1.8, as specified by Altman, with an additional screen requiring a current ratio of less than 0.5 as reported by the companies on the latest quarter. We believe this additional requirement shortens the time period of expected bankruptcy occurrence, as the ratio is an indication of whether or not a firm has enough resources to pay its debts over the next 12 months. Furthermore, we limit our screen to stocks trading in US exchanges with market capitalization greater than $1 million.
The result of our screen is shown below:
Our short-only portfolio consists of 30 companies, ranked according to their respective Z-scores. Most of the companies in the portfolio have Z-scores that are much lower than Altman’s lower limit of 1.8. Such negative scores indicate a much higher probability of bankruptcy than the average company studied by Altman for his original study.
The ValueHuntr Short-Only Portfolio can be tracked real-time HERE.