I am regularly reading and hearing that the practice of buying cheaply valued shares is a dying art and may even be a dead one. Since the financial crisis of 2008 many investors have flocked to the comfort and relative safety of quality growth stocks and have benefited handsomely from doing so.
Those that have tried to make money from value investing have had a much harder time. In many instances the reason for their poor experience was simply that what they were buying wasn’t undervalued in the first place.
All too often they bought into a weak business that faced many challenges and was actually getting weaker and not going through a temporary rough patch. This is the classic value trap that has the capacity to seriously harm the investor and knock big holes in their portfolio’s performance, which needs to be avoided if at all possible.
In many ways investing is very similar to other parts of life in that you often get what you pay for. Paying up for quality and reliability often ends up as giving you better value over the long run, which is why expensive cars, electrical appliances and clothes can give many years of good service and cheap stuff that lasts what seems like five minutes has to be replaced time and time again and ends up costing you more.
Yet, I have thought for some time that investors are being asked to pay too much for quality growth stocks, but they have continued to increase in price. Sooner or later valuation will have to matter with these shares and share prices cannot continue to increase faster than profits and cash flows. But trends that seem irrational have a tendency to carry on for longer than we think possible.
Can the same be said for the other end of the stock market?
The economic lockdown has kicked the stuffing out of many businesses and come close to beating the living daylights out of some share prices.
The UK economy has had one of the worst experiences from the lockdown due to its heavy exposure to labour intensive, service sector businesses. Companies with anything to do with travel, aerospace, leisure or very economically sensitive sectors such as advertising have seen their share prices decimated as investors question their very existence in a changed world.
However, this is often the backdrop that allows big future gains to be made. Investor John Templeton is often quoted as saying that you should buy at the point of maximum pessimism and when there is blood on the streets and there can be no doubt that there are many UK-listed shares that fit that description or are close to it.
Identifying distressed shares is easy, working out whether you can make money from them is much more difficult. To do so, they first have to survive.
At the time of writing, I found 93 UK listed shares where the share price had fallen by more than 50 per cent since the start of the year.
Unsurprisingly, the biggest sources of distress are found in the more domestic focused FTSE 250 and Small Cap indices. Many of the companies behind these shares are literally staring into the abyss as a consequence of Covid-19 and the reactions to it.
In the absence of a vaccine or the development of herd immunity in the population it is entirely reasonable to ask how many people will take flights or go to pubs and restaurants over the next few years.
Many businesses need to have lots of customers just to give them a chance of making a modest profit. When social distancing reduces demand by sometimes a third, a half or almost completely, then trouble has quickly followed. Profits have been decimated and in some cases are expected to become losses.
If we take a selection of very distressed UK shares (see table) then the warning signs are flashing very brightly indeed. One of the most simple and most easily observed signs of a distressed share is when the value of its debt significantly exceeds its market capitalisation or equity valuation.
There are a number of severe examples of this in companies such as Cineworld CINE), Saga (SAGA), Capita (CPI) and John Menzies (MNZS). This is evidence of extreme pessimism and also risk, but they also give the investor the kind of leverage that any improvement in a company’s trading performance could rapidly feed through to significant share price gains.
The other possibility is that the company could go bust if the economy takes another step down.
Examining bankruptcy risk with the Altman Z-Score
Back in the late 1960s, Edward Altman, a professor of finance at New York University, set about finding a way to predict companies that were heading for bankruptcy. Mr Altman studied lots of non-financial companies and crunched 22 different financial ratios with numbers taken from their accounts. What he came up with was a formula that has proven to be a reasonably good predictor of future financial distress that has stood the test of time. It’s called a Z-Score.
This is how you calculate it:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 x4 + 1.0 X5
Mr Altman found the five financial ratios (labelled X1 to X5) held the key to predicting trouble ahead. Let’s have a look at them in turn and see why they are useful.
X1: Working capital/total assets
Working capital is the difference between a company’s current assets (things that can be turned into cash within one year) and current liabilities (bills or debts that have to be paid within a year). It is a measure of a company’s liquidity. Mr Altman saw that a low or negative level of working capital relative to the size of the company (its total assets) was a sign of weak finances.
X2: Retained profits/total assets
Retained profits are a company’s cumulative total profits that have not been paid out to shareholders since it was created. Small retained profits are found in weak or young companies that are more likely to fail. Companies with a high retained profits to total assets ratio tend to have financed their business with profits rather than relying on lots of debt – a good sign according to Mr Altman.
X3: Trading profits/total assets
This is a way of showing how productive a company is. Good, strong companies have big profits in relation to their assets. Weak ones do not. Mr Altman found that this was a particularly good predictor of bankruptcy and was even better than looking at a company’s cash flow. I agree about focusing on returns, but use return on capital employed (ROCE) instead as my go to measure of them.
X4: Market value of equity/total liabilities
This measure shows how far a company’s assets can decline in value (measured by the market value of equity or market capitalisation) before they are less than its liabilities, which could mean that it is insolvent. The debt to market capitalisation ratio used in the table is asking a similar question.
X5: Sales/total assets
This shows the ability of the company’s assets to generate sales – the lifeblood of any company. Mr Altman later adapted the Z-score for use with non-manufacturing companies. It is almost the same as the original one, but with the last ratio (sales/total assets) removed as non-manufacturers don’t tend to have large asset bases.
What do the Z-score numbers mean?
According to Mr Altman, strong companies should have a Z-score of 3 or more. A company with a Z-score of less than 1.8 is seen as having problems and could be heading for bankruptcy. If you come across a company with a Z-score of less than 3 then it probably makes sense to have a good hard look at its finances to see if there is anything to worry about.
In summary, the rough guide for interpreting a Z- score is:
▪️ Above 2.99. The company is considered safe based on the five financial ratios.
▪️ 1.8 to 2.99. Are grey areas that suggest caution. There is a good chance of the company going bankrupt within the next two years.
▪️ Below 1.80. The score indicates a high probability of distress or even bankruptcy within the next two years.
If we take Altman Z-Scores at their face value then a lot of the companies in our table are in big trouble and the share price has reacted accordingly. That said, my view is very few – or any – of them will go bust. Many have asked their shareholders for fresh money already and their stock market listing means that they can do so again. If these businesses were privately owned I’d take a more pessimistic view. However, further economic lockdown is a real risk and could push many companies’ finances over the edge.
Like most financial ratios, the Z-Score’s key weakness is that it is backwards looking when it is the future we are all concerned about. Saying this, I think it’s a very useful number, but needs to be considered as part of a broader analysis of a company’s prospects. At the moment, I think it could be just as good a predictor of future share placings or rights issues as bankruptcy as far as quoted companies are concerned.
Are very distressed shares investable or just too risky?
For many investors, distressed shares are too risky as they rightly place a strong importance on the ability to sleep well at night and not worry about one of their stocks blowing up.
For those with a more adventurous risk appetite, distress spells opportunity and can lead to big profits with a bit of luck and good judgement. The problem facing us all now is trying to work out what the future might look like in a world that has seen its biggest social and economic shock in living memory.
Forecasting future profits is difficult, but investors don’t necessarily need to. Instead they can try and work out what the current market valuation of a company is implying about its sustainable profits. They can do this by looking at something known as earnings power value or EPV for short.
EPV gives you an estimate of the value of a company (in this case its enterprise value or the market value of all its assets) if you assume that its current profits are unchanged forever. This is a very simple calculation that can be done in a few different ways. I do it by dividing a company’s operating profit by an estimate of its pre-tax cost of finance (a complicated subject that I won’t discuss here, but is the weighted average of the returns required by lenders and shareholders).
For argument’s sake, let’s say a company’s cost of finance is 10 per cent. Its EPV is therefore: operating profit/10 per cent.
To work out the implied sustainable profits at a current share price we take the current enterprise value (market capitalisation plus net debt, plus minority interests plus preferred equity plus pension deficit) and multiply it by the cost of finance. We can then take the answer and compare it with a company’s historic and forecast future profits as I have done in the table.
Most valuations now assume a permanent fall in sustainable profits going forward with a couple of exceptions (implied profits are less than last reported profits).
If analysts’ forecasts are vaguely in the right ballpark then shares such as Dart Group (DTG), ITV (ITV), National Express (NEX), Cineworld (CINE), Senior (SNR) and perhaps Ted Baker (TED) are worthy of consideration on a three-year view.
Apart from hard numbers, I would also look for other signs of optimism such as significant director buying, which can be seen at Ted Baker and Senior back in June. I also note that the chairman of easyJet (EZJ) bought half a million pounds worth of shares in early August.
Some basic questions to consider
Investing is not a painting by numbers exercise even though it tends to involve a lot of numbers. For distressed value investing to be successful the investor has to be very confident that the business they are looking at has problems that are temporary and are fixable. Taking time to understand a company’s strategy to cope with its changed circumstances is therefore vitally important. If they are satisfied that the company has a good plan then buying at a big discount to its underlying value – the often mentioned margin of safety – is a must.