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I don't make this stuff up. I'm not that smart.

Altman Z-Scores

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This entry provides a list of Altman Z-Score stocks at or below 1.81 and 3.00 based on an August 6 screen of the non-financial stocks populating the S&P 500. The Z-Score is a popular, academically tested, and imperfect indicator of bankruptcy risk. Nevertheless, it can be informative, as one input among many considered by the investor.

Warren Buffett has argued that the secret to investing is to not lose money. This is a concept that Investors Business Daily‘s CAN SLIM method employs (created by William O’Neil). CAN SLIM urges investors to establish close stop-loss levels (around 8 percent, if memory serves).

[By the way, I am not an advocate of the CAN SLIM method, and, ordinarily, Warren Buffett and William O’Neil should not mentioned in the same paragraph — so different are their approaches –, but that is a subject for another time.]

Peter Lynch, on the other hand, has famously stated “The key to making money in stocks is not to get scared out of them.” In other words, have the courage of your convictions and adopt a posture of buy and hold. John Bogle agrees, when he argues that mutual fund investors should buy and hold index funds to avoid the weight of costs attributable to turnover rates, management fees, capital gains costs, etc..

[By the way, just as O’Neil and Buffett should not ordinarily be mentioned together, Bogle and Lynch should not be linked … ordinarily. Bogle urges purchase of index funds for all the reasons just mentioned and his research supporting Reversion to The Mean, while Lynch actively managed a fund that defied the market’s mean.]

So, how do we square Buffett and O’Neil, on the one hand, with Lynch and Bogle, on the other hand? In other words, how do we avoid buying and holding stocks at risk of bankruptcy?

Well, this is where the Altman Z-Score comes in the picture. Stocks with Altman Z-Scores of less than 1.81 are considered bankruptcy candidates — predicting bankruptcy up to two years out with a success rate of around 70 percent (sometimes more).

Now, that 70 percent success rate sounds impressive, but it also implies a 30 percent level of inaccuracy.

Created by NYU finance Professor Edward Altman, there are actually several different Z-Scores — a generic version and others that are industry specific (designed to lower the false positive percentage). For our purposes, we will use the generic version.

The calculations for the Z-Score are:


[Think of the numbers at the start of each line as their regression weightings — understanding that the basis of each ratio will be different. In other words, Net Working Capital divided by Total Assets is not half as important as Earnings Before Interest and Taxes divided by Total Assets, since the average for each will be different.]

The Z-Score can (but not always) indicate which companies are at increased risk of bankruptcy. This means the Z-Score can be used in two ways. First, it can suggest which stocks to avoid, even if they appear undervalued by some other measure (such as Discounted Cash Flows, Book Value, Replication Value, Price-to-Book, Price-to-Sales, etc.). Second, if the investor can identify which low-Z-Score firms fall into the 30-percent false-positive camp but is strongly under-valued or likely to post above-average returns, that stock may significantly out-perform the market, if the market has priced the Z-Score into the current stock price.

Last evening (August 6, 2008 ) I ran my automated screen of the S&P 500, minus the stocks of financial firms (banks, insurance, investment houses). 413 stocks remained. Of them, 27 fell below the 1.81 threshold. They are:

Incomplete data, due to this being reporting season, forced elemination of a small number of stocks for which incomplete data was available. They are:





The following stocks may be undervalued by 50 percent or more, by Discounted Cash Flow analysis:

Name Discount
CTX 0.85
F 0.82
KBH 0.93
PHM 0.74
S 0.59

The DCF used here assumes the company will grow Free Cash Flows over the next decade at the same rate as for the last decade. I will leave it to the reader to judge whether this is a reasonable assumption for a list that includes at least one home builder and one US automotive company. In other words, close due diligence should be conducted before identifying any on this list as an attractive investment based on its discount — even if concluding that the Z-Score fails to accurately reflect the company’s future prospects.

Companies that post Z-Scores falling between 1.82 and 3.00 (inclusive) are considered to be in a gray zone of uncertainty when it comes to bankruptcy risk. Here are the results from last night’s screen:

Name ALTZ Price Name ALTZ Price
AEE 2.31 40.04 KFT 2.43 32.28
AEP 2.29 38.87 LIZ 2.20 14.17
AET 2.39 43.10 LUV 2.27 16.46
AN 2.93 11.39 M 2.19 19.68
AVY 2.36 45.44 MDP 2.96 27.14
AW 2.12 12.66 MOT 2.38 9.50
BA 2.41 65.40 NOVL 2.17 5.38
CAT 2.50 70.51 NWL 2.66 18.17
CBS 2.30 16.70 NYT 2.27 13.50
CCE 2.01 17.46 PBI 2.21 34.60
CEG 2.71 74.05 PGN 2.56 42.33
CIEN 2.50 17.85 PNW 1.93 33.36
CSC 2.16 45.75 POM 2.24 24.80
D 2.82 42.17 PPG 2.87 61.96
DDS 1.92 10.46 Q 1.96 3.45
DE 2.54 67.41 RIG 2.91 132.20
DUK 2.77 17.44 RRD 2.42 27.62
EIX 2.79 46.88 SEE 2.56 22.38
FIS 2.99 22.50 SLE 2.81 14.52
FPL 2.94 57.21 STZ 1.85 22.00
GT 2.33 20.23 TYC 1.86 44.32
IACI 2.38 17.89 UIS 1.94 3.92
ITT 2.46 67.96 VMC 2.13 68.40
JAVA 2.29 10.19 WHR 2.40 78.84
JBL 2.90 17.14 WLP 2.79 53.79
JCI 2.92 31.10

Along with the list of stocks discounted by 50 percent or more by DCF:

Name Discount
BA 0.55
DDS 0.57
NOVL 0.59
CBS 0.63
STZ 0.66
IACI 0.68
M 0.73

Some may wonder whether these represent “short” lists — i.e., a list of stocks ripe for shorting? Personally, I do not short, and I do not recommend it. 70 percent of options contracts expire worthless, and, with Put options, the down-side risk is unlimited. As adults, however, we are entitled to play on the trapeze without a net — otherwise, what is a Las Vegas for? Nevertheless, I should close as I began by noting Buffett’s admonition that the secret to investing success is to not lose money. Shorting seems destined to challenge that principle, if the odds of failure are given serious consideration. Lynch maintained that investing success was a matter of picking winners in a simple majority of cases, where a portfolio comprised of 60 percent winners is wildly successful. A small number of what he calls “multi-baggers” will account for the lion-share of the investor’s success. Multi-baggers are stocks that double (or more) in value. With stock investing, only the long investor can realize this level of success with any single holding.

[Note: These results follow from each company’s 10K SEC filings — not the 10Q’s — as provided by Morninstar. As always, the reader is encouraged to check my numbers. I’ve made mistakes in the past and will surely make them in the future. I should note, as well, that, while I tend to avoid low Z-Score stocks, I have purchased them, as well. There are few absolutes in business, and the key is to understand the strengths and limitations of each approach and, equally important, the logic behind your own choices. Your investment decisions, therefore, are yours, for good or Ill. So, regardless of the writer or pundit, verify the logic behind their recommendations and take ownership of the final decision.]


Written by rcrawford

August 7, 2008 at 9:25 pm

Posted in Investments

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3 Responses

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  1. I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you down the road!


    August 12, 2008 at 7:37 pm

  2. Is there a mutual fund or an ETF that pool low Z-Score stocks to spread the risks of shorting stocks?

    Robert Kelly

    May 30, 2010 at 5:24 am

    • None, Robert, of which I am aware. Since I do not short, it is not something I track with any consistency (in bulk, that is). I do check the z-scores for stocks considered for long positions, but, because this is based on screens for strong companies, low-z-score stocks are relatively rare.


      June 3, 2010 at 5:57 am

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