Entries categorized as ‘Academic’

Using Altman’s Z-Score to Create a Short-Only Portfolio

January 8, 2010 · 7 Comments

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

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.


Categories: Academic · Analysis
Tagged: altman, bankrupt, bankruptcy, model, portfolio, regression, short, z-score

How to Make Presentations to Portfolio Managers

July 23, 2009 · 1 Comment

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by Bill Miller, Portfolio Manager of Legg Mason

I want to emphasize that if you go into capital markets, you will realize that portfolio managers have ultra-short attention spans. And there is basically no successful portfolio manager of my acquaintance who has ever wanted to hear a story longer than ninety (90) seconds.  Peter Lynch, when a senior analyst came into a pitch him a stock, would turn on an egg timer for 90 seconds.  The analyst had to complete the presentation within 90 seconds and be out of there.

If you can’t get the portfolio manager’s attention within that time with a convincing case then they will assume that you either don’t have a convincing case or you are not able to articulate it, and you should go back and figure it out.

Stories not Atoms

The world is made of stories, not of atoms. Most people think of the world as analyzing atoms and its constituent parts, and then I am going to figure out how to value it and then describe it.  The alternative way to think about it is to construct a convincing story. Take all your material together and construct a convincing story.

If you speak to a portfolio manager, the best thing to say is, “I want to talk to you about Homestore (HOM).  It is at $2.25. The 52-week range is $4 to $2 and the all time high was $100 in 2000. I think it is a buy for the following five reasons:

1) Bam
2) Bam
3) Bam
4) Bam
5) Bam

The stock is trading a $2 and change. I think it is worth $6 or $8 or whatever.  Here is why I think it is worth that.  Here are the risks. Present no more than five positive points, three negative points, and what the business is worth. Then you are done.

Categories: Academic
Tagged: bill miller, legg mason, presentations, stock pitch

Does Stock-Market Data Really Go Back 200 Years?

July 17, 2009 · Leave a Comment

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By Jason Zweig (WSJ)

As of June 30, U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years.

Still, brokers and financial planners keep reminding us, there’s almost never been a 30-year period since 1802 when stocks have underperformed bonds.

These true believers rely on the gospel of “Stocks for the Long Run,” the book by finance professor Jeremy Siegel of the Wharton School at the University of Pennsylvania that was first published in 1994.

Using data assembled by other scholars, Prof. Siegel extended the history of U.S. stock returns all the way back to 1802. He came to two conclusions that became articles of faith to millions of investors: Ever since Thomas Jefferson was in the White House, stocks have generated a “remarkably constant” average return of nearly 7% a year after inflation. (Adding inflation at 3% yields the commonly cited 10% annual stock return.) And, declared Prof. Siegel, “the risks of holding stocks decrease over time.”

There is just one problem with tracing stock performance all the way back to 1802: It isn’t really valid.

Prof. Siegel based his early numbers on data first gathered decades ago by two economists, Walter Buckingham Smith and Arthur Harrison Cole.

For the years 1802 through 1820, Profs. Smith and Cole collected prices on three dozen banking, insurance, transportation and other stocks — but ended up including only seven, all banks, in their stock-market index. Through 1845, they tracked 19 insurance stocks, but rejected 95% of them, adding only one to their index. For 1834 onward, they added a maximum of 27 railroad stocks.

To be a good measure of stock returns, an index should be comprehensive (by including many stocks) and representative (by including the stocks commonly held by investors). The Smith and Cole indexes are neither, as the professors signaled in their 1935 book, “Fluctuations in American Business.” They cherry-picked their indexes by throwing out any stock that didn’t survive for the whole period, whose share prices were too hard to find or whose returns seemed “inflexible,” “erratic,” or “non-typical.”

The database of early U.S. securities at EH.net has so far identified more than 1,000 stocks that were listed on 10 different exchanges — including Charleston, S.C., New Orleans, and Norfolk, Va. — between 1790 and 1860. Thus the indexes relied on by Prof. Siegel exclude 97% of all the stocks that existed in the earliest years of the U.S. market, and include only the bluest of the blue-chip survivors. Never mind all of the canals, wooden turnpikes, rubber-hat companies and the other doomed stocks that investors lost millions on — and whose returns may never be reconstructed.

There is a second problem with Prof. Siegel’s data.

In an article published in 1992, he estimated the average annual dividend yield from 1802-1870 at 5.0%. Two years later in his book, it had grown to 6.4% — raising the average annual return in the early years from 5.7% to 7.0% after inflation.

Why does that matter? By using the higher number for the earlier period, Prof. Siegel appears to have raised his estimate of the rate of return for the entire period by about half a percentage point annually.

Prof. Siegel calculated in his 1992 article that $1 invested in stocks in 1802 would have grown, after inflation, to $86,100 by 1990. In his book just two years later, however, he estimated that $1 in 1802 would have mushroomed into $260,000 by 1992. But in 1991 and 1992, stocks gained 30.5% and 7.6%, respectively, which should have taken the cumulative return up to only about $121,000. Nearly all of that huge difference seems to have come from Prof. Siegel’s revised number for early dividends.

“I made an estimate of the dividend yield,” Prof. Siegel told me, “through looking at a smaller set of securities and projecting it out.” Money manager Robert Arnott of Research Affiliates LLC has recently estimated the early dividend yield at 5.2%. “Arnott has a much lower estimate, and that’s a big difference,” said Prof. Siegel. “I mean, I don’t know what more to say.”

I later called Prof. Siegel to ask him again about the difference between his original research and his book, but he didn’t get back to me by press time.

What, then, are the odds that stocks will continue to lag behind bonds for the long run? The sad truth is that history can’t tell us the answer. The 1802-to-1870 stock indexes are rotten with methodological flaws. So we have only the period since then, or four distinct and complete 30-year stretches of stock returns, to base our long-term investment decisions on.

Another emperor of the late bull market, it seems, has turned out to have no clothes.

Categories: Academic · Investing · News
Tagged: Stocks, performance, jason zweig, bonds

Today’s Profile: Nassim Taleb

July 15, 2009 · Leave a Comment

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Risk guru and author Nassim Taleb discusses the central theme of his book “The Black Swan: The Impact of the Highly Improbable”. Taleb discusses The Black Swan in relation to predicting the future, learning from the consequences of the unknown, and the power of randomness in the markets. In general, a Black Swan is an event that is difficult or impossible to predict based on historical data or information, such as the Great Depression, the Mortgage Crisis, the Internet Bubble, etc.

Categories: Academic
Tagged: black swan, Investing, taleb

How Much Information is Enough?

July 8, 2009 · Leave a Comment

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How much information does an investor need to make rational investment decisions? That is a question whose answer varies greatly depending on the investor. Investing with too little information certainly increases the risk associated with the investment. But on the other hand, too much information may take a long time to dig through, possibly increasing costs associated with research as well as increasing the chance of missing other great investment opportunities.

It would be a serious mistake to think that all the facts that surround a particular investment could be known. Not only many questions remain unanswered, but most certainly not all the right questions may have been asked. Even if the present could somehow be perfectly understood, investments are dependent on outcomes that cannot be accurately foreseen.

Some investors refer to Pareto’s Law, or the “80/20” principle, when discussing the time they spend on researching investment opportunities. The principle was founded when Italian economist Pareto noticed that 80% of the country’s wealth was owned by 20% of the population. Generally, the law states that, for many events, roughly 80% of the effects come from 20% of the causes. The interesting and most important aspect of this principle is its widespread presence over a variety of matters such as: 80% of all sales revenues come from 20% of the customers, most people spend 80% of their time with 20% of friends, 80% of gains in a stock market portfolio comes from 20% of the stocks in that portfolio, etc.

Could it be that 80% of the valuable information we need to make a rational investment is found in the first 20% of time spent researching such situation? It seems likely, and investors such as Seth Klarman and George Soros seem to think so. I think what is important to remember is that even if everything could be known about an investment, the reality is that business values are not carved in stone. The best investors are those which make rational investment decisions even with incomplete information.

Categories: Academic
Tagged: baupost, baupost group, george soros, information, Klarman, pareto law, Value Investing

How the Finance Gurus Get Risk All Wrong

July 6, 2009 · Leave a Comment

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We recently came across an interesting article written by Nissim Taleb, author of “The Black Swan” and “Fooled by Randomness”. Mr. Taleb has an interesting take on investment risk. According to him, risk is often misrepresented because it it always measured on the framework of a bell curve. Hence, it does not account for rare-occuring, possibly catastrophic events, such as the collapse of the housing market in 2008. He proposes a “fractal” theory to understand these types of risks. The article can be found here.

Categories: Academic
Tagged: Investing, nassim taleb, black swan, fractal theory, risk

Peter L. Bernstein on Risk Management

July 1, 2009 · Leave a Comment

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Peter L. Bernstein, who passed away this past June 5th, recently spoke about the concept of risk as it relates to investment management. The main idea of his discussion is that we cannot tell or forsee what is going to happen in the future. Therefore, investors should not spend time calculating what risks are, but rather getting prepared to confront those risks succesfully.  Though we believe that risks can be mitigated by careful analysis, we agree with his general sentiment, best expressed in a seminar he conducted in 1997:

“Today’s obsession with risk management focuses too intently on the instruments of the management and measurement of risk. The more we stare at the jumble of equations and models the more we lose sight of the mystery of life. All too often, reason cannot answer. Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty”

His short talk on risk management in the world of investments can be found here.

Categories: Academic
Tagged: investments, peter berstein, risk management

Back to the Future with Benjamin Graham

June 29, 2009 · Leave a Comment

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In early 1970’s Ben Graham wrote a prophetic piece about future threats to equities, where he rightly predicted that Wall Street greed would always be the biggest threat to equity investors. In some ways, the picture Graham paints of the 1969-1974 market sentiment is similar to today’s. A fragment of the article is included below.

Experience suggests therefore that the various threats to equities are not very different from other obstacles that common stocks have faced and surmounted in the past. My prediction is that stocks will surmount them in the future.

But I cannot leave my subject without alluding to another menace to equity values not touched on in my terms of reference. This is the loss of public confidence in the financial community growing out of its own conduct in recent years. I insist that more damage has been done to stock values and to the future of equities from inside Wall Street than from outside Wall Street. Edward Gibbon and Oliver Goldsmith both wrote that, “History is little more than a register of the crimes, the follies and the misfortunes of mankind.” This phrase applies to Wall Street history in the 1968 to 73 period, but with more emphasis to be given to its crimes and follies than to its misfortunes.

 I have not time even to list all the glaring categories of imprudent and inefficient business practice, of shabby and shoddy ethics perpetrated by financial houses and individuals, without the excuse of poverty or ignorance to palliate their misdemeanors. Just one incredible example: Did anyone ever hear of a whole industry almost going bankrupt because it was accepting more business than it could handle? That is what happened to our proud NYSE community in 1969, with their back-office mix ups, missing securities, etc. The abuses in the financial practices of many corporations during the same period paint the same melancholy picture.

It may take many years—and new legislation—for public confidence in Wall Street to be restored and in the meantime stock prices may languish. But I should think the true investor would be pleased, rather than discouraged, at the prospect of investing his new savings on very satisfactory terms.

To pension-fund managers, especially with large and annual increments to invest, the prospects are especially inviting. Could they have imagined five years ago that they would be able to buy AAA bonds on an eight to nine per cent basis, and the shares of sound companies on a 15 per cent or better earnings yield? The opportunities available today afford a more promising investment approach than the recent absurd idea of aiming at, say, 25 per cent market appreciation by shifting equities among institutions at constantly higher price levels—a bootstrap operation if there ever was one.

Let me close with a quotation from Virgil, my favorite poet. It is inscribed beneath a large picture panel at the head of the grand staircase of the Department of Agriculture building in Washington. It reads:

 “O fortunati nimium.. .(etc.) Agricolae!”

Virgil addressed this apostrophe to the Roman farmers of his day, but I shall direct it at the common-stock buyers of this and future years:

“O enviably fortunate Investors, if only you realized your current advantages!”

- Benjamin Graham

Categories: Academic · Value Investing
Tagged: Ben Graham, threat equities

Settling for Par: Pros More Likely to Play It Safe

June 17, 2009 · Leave a Comment

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(This is an article, which appeared in the Sports section of the NYT, has lessons beyond the golf course)


By Alan Schwartz

When PGA Tour golfers from Tiger Woods down to the greenest rookie draw back their putters this week at the United States Open, their scorecards will be sabotaged by a force as human as it is irrational: risk intolerance.

Even the world’s best pros are so consumed with avoiding bogeys that they make putts for birdie discernibly less often than identical-length putts for par, according to a coming paper by two professors at the University of Pennsylvania’s Wharton School. After analyzing laser-precise data on more than 1.6 million Tour putts, they estimated that this preference for avoiding a negative (bogey) more than gaining an equal positive (birdie) — known in economics as loss aversion — costs the average pro about one stroke per 72-hole tournament, and the top 20 golfers about $1.2 million in prize money a year.

Contrary to most academic studies involving sports, at which athletes typically scoff, a handful of the tour’s top putters did not dispute this finding. Simply put — if not putt — they admitted to being spooked enough by bogeys that they will ultimately cost themselves strokes to avoid them. Call it the bogeyman.

“Par putts just seem to be more critical because if you miss you drop a shot — if you miss a birdie putt, it doesn’t seem to have the same effect,” said Jim Furyk, one of the tour’s best putters.

Added Justin Leonard: “When putting for birdie, you realize that, most of the time, it’s acceptable to make par. When you’re putting for par, there’s probably a greater sense of urgency, so therefore you’re willing to be more aggressive in order not to drop a shot. It makes sense.”

Of course, it makes no sense at all: each stroke counts as one on a scorecard, whether for eagle or triple-bogey on any particular hole. The goal is to finish with the fewest strokes, regardless of what each might be artificially termed. All else being equal — distance from the cup, one’s proximity to the lead or cut, the course difficulty and so on — putts should be handled the same way.

But they are not, according to the study of almost 200 tour professionals from 2004 through 2008. Using data the tour regularly records on every ball’s green location accurate to the nearest inch, the professors found that birdie putts were made about 3 percent less often than otherwise identical putts for par. (In effect, players tell themselves before birdie attempts, “Let’s just get close,” rather than, “I have to make this.”) Given that players typically attempt nine birdie putts per round, this cost each golfer about one stroke per tournament — which can translate to hundreds of thousands of dollars in prize money.

The professors, Devin Pope and Maurice Schweitzer, seemingly anticipated every “But what about?” reflex from golf experts. The tendency to miss birdie putts more often existed regardless of the player’s general putting or overall skill; round or hole number; putt length; position with respect to the lead or cut; and more.

As would be expected, the difference decreased on routine short putts and also decreased very far from the hole, where the chance of making the putt is small to begin with. It peaked on putts from about 6 to 12 feet. Even Woods, roundly considered the best putter ever, exhibited the trait at roughly the tour average.

The finding may become significant among behavioral economists, many of whom have suspected that the loss aversion found through contrived experiments might not be demonstrated by actual, expert competitors vying for high stakes. The paper is being submitted this week for publication in an economic journal.

“Even experienced professionals playing for high stakes are not rational,” Pope said. “Tiger Woods, the model of perfection and what an economist would think of as a rational agent, even he exhibits these biases. And if he exhibits these biases, why not business leaders? There are a lot of applications.”

Rather than resist any insight from ivory tower academics, several golfers admitted to handling identical birdie and par putts differently — and appeared somewhat amused at being found out. Geoff Ogilvy, who made par putts 4.1 percent more often than birdie putts from the same distance, said: “A par putt seems more final. It shouldn’t make any difference, should it?” And Paul Goydos, who showed the effect at 4.4 percent, said it probably affected him even more on putts for eagle.

“If I’ve got a 25-footer for eagle, it seems like I’m more conservative than with a 25-footer for either birdie or par for whatever reason,” Goydos said. “I think the worst thing you can do is three-putt for par on a par 5. That’s one that drives me more crazy than anything else. Maybe that’s why I’m at the very bottom of the tour in eagles made.”

But just as quickly as pro golfers admitted to their costly habit, they dismissed the idea of being able to do much about it. Stewart Cink, who showed a 3.3 percent effect, said that try as he might, he would never be able to convince himself that every putt is the same.

“You can’t fool yourself,” Cink said. “But this is one of the reasons why we use sports psychology, and we try to have a preshot routine so we do the same thing, approach every putt the same way. It’s not always glamorous, and it’s not always possible in reality.”

The psychological preference to avoid a perceived penalty (losing a stroke relative to par) rather than go for a perceived gain (gaining a stroke) has some benefit. Golfers tended to leave their conservatively stroked birdie putts slightly closer to the cup than more aggressively missed pars — leading to their making their follow-up shot more often. But that temporary gain was far outweighed by the overall cost in strokes.

The birdie-versus-par effect varies in ways that many golfers would instinctually predict. The tendency to make similar birdie putts less often than pars becomes less prevalent with each tournament round as players are judged more against one another than against par. The elite tour players generally show less of the trait than marginal ones. And the difference decreases as a player sees himself or his partners handle a particular green.

But the effect is always there, even if a good reason for it is not.

“A 10-footer for par feels more important than one for birdie,” said Goydos, a two-time winner on the tour. “The reality is, that’s ridiculous. I can’t explain it in any way other than that it’s subconscious. And pars are O.K. — bogeys aren’t.”

Categories: Academic
Tagged: Academic, golf, Investing

Q &A with John Bogle

June 9, 2009 · Leave a Comment

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Categories: Academic
Tagged: financial crisis, john bogle