How to avoid investing in distressed stocks

Thursday, Nov 10 2011 by
19
How to avoid investing in distressed stocks

Business distress and bankruptcy can spell disappointment or even disaster for investors – and at a time of economic uncertainty, making that critical call between risk and reward is an increasingly challenging prospect. In the current environment investors ought to be scrutinising the financial health of their portfolio stocks and applying extra due diligence when it comes to new investments – but how? One excellent starting point is applying one of the longest running and best tested bankruptcy screening tools available to investors – the Altman Z-Score

Attempting to figure out which stocks are at risk of failure is nothing new in investment circles. However, getting to grips with the subject of quoted company failure is difficult because for every headline-grabbing disaster there are a number of others companies – often at the smaller end of the market – that simply fade away, leaving only the investors involved feeling battered and bruised. A classic example was the administration of stricken healthcare recruitment business Pinnacle Staffing Group this summer, which marked the sorry end to five years of underachievement and investor frustration. Back in September 2006, investors were given the option to buy in to the promising recruitment spin-out from health and social care services group Nestor Healthcare. It culminated in perpetual losses and Pinnacle’s remaining assets ultimately being sold off for just £17,000. Meanwhile, investors that stuck with Nestor did rather better when that company was sold earlier this year to private equity-backed Saga for £124 million. Financial distress or insolvency drove twenty-two companies to delist from the Alternative Investment Market during the first half of 2011, according to accountancy group UHY Hacker Young, although the figure dropped dramatically to just three companies in the third quarter – F.T.S.- Formula Telecom Solutions, Pinnacle Staffing and Agua Terra. Despite signs of improvement, industry-watchers are broadly agreed that economic conditions remain brutal and uncertain and that investors should be acting with care.

So how does an investor spot a company that might go under? The Altman Z-Score has been a part of the investor toolkit for more than 40 years but is not as well-known as it should be. It was developed by New York University finance professor, Edward I. Altman, who used a combination of five weighted business ratios to estimate the likelihood of financial distress. It was initially created to test the…

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Premier Foods plc is a food company. The Company is engaged in the manufacture and distribution of branded and own label food and beverage products. The Company's segments include Grocery, Sweet Treats and International. The Grocery segment primarily sells savory ambient food products. The Sweet Treats segment sells sweet ambient food products. The International segment has been aggregated within the Grocery segment for reporting purposes. The Company offers a range of brands, such as Ambrosia, Bisto, OXO, Paxo, Sharwood's, Loyd Grossman, Homepride, Batchelors, Smash, Bird's, Paul Hollywood, Marvel and Angel Delight. Its Grocery strategic business unit (SBU) includes cooking sauces and accompaniments, flavors and seasonings, Quick meals and soups, and ambient desserts. Its Sweet Treats SBU includes the Company's cake brands, such as Mr. Kipling, Cadbury and Lyons. Its International SBU is focused on new markets across the world. more »

LSE Price
32.6p
Change
1.2%
Mkt Cap (£m)
275.7
P/E (fwd)
3.9
Yield (fwd)
n/a



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6 Comments on this Article show/hide all

Michael barton 11th Nov '11 1 of 6
1

Oh. very good indeed. Of course many companies have results which vary from quarter to quarter, half year to half year and indeed annually (eg exploration companies) but any formula which attempts to reduce risk by pointing in a positive direction is of great use to investors and maybe to the company itself .

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marben100 13th Nov '11 2 of 6
1

Useful article, and I look forward to Stockopedia Premium. However, you say:

 

The fourth measure is T4 (market cap / total liabilities), which measures how far the company’s assets can decline before it becomes technically insolvent.

 

but market cap. has nothing to do with solvency? Solvency is surely the ability to pay debts as and when they fall due. The relevance of market cap., however, is that it indicates the firm's ability to pay off debts by issuing equity. A low T4 indicates that the firm couldn't pay off debts by issuing equity, without massively diluting shareholders.

Cheers,

Mark

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sodc 14th Nov '11 3 of 6
1

The (T2) figure shown of -£159.1m (the company's retained earnings).
Can you please show how this figure is calculated from the Premier Food fundamentals.
The 'retained earnings' for 31 Dec '10 shows -1,040.70
and -964.5m for 31 Dec '09

Also, the (T4) second figure of (£2.51bn) It's 'total liabilities'.
How and from what figures is that total made up of from the fundamentals.

Regards
D

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Murakami 14th Nov '11 4 of 6
1

In reply to post #61879

Thanks for the question. In terms of the Retained Earnings, as we're using the Reuters data-set, the calculation above is using what they call Retained Earnings (Accumulated Deficit). This include all reserves as reported in shareholders’ equity and is actually the sum from the Preliminary Results of i) Profit and loss reserve of -£1,040.7m, ii) the Merger reserve of £890.7m, and Other Reserves of -£9.3m, which equals -£159.1m. Altman doesn't provide much detail on this point in his paper but he does say: 

 

Retained earnings is the account which reports the total amount of reinvested earnings  and/or losses of a firm over its entire life.  The account is also referred to as earned surplus.  It  should be noted that the retained earnings account is subject to "manipulation" via corporate quasi-reorganizations and stock dividend declarations.  While these occurrences are not evident in this study, it is conceivable that a bias would be created by a substantial reorganization or stock dividend and appropriate readjustments should be made to the account.

 

So, perhaps, including the Merger Reserve actually flatters the company unduly. If one just used the P&L reserve figure, obviously then the T2 ratio would be even worse.  In this specific case, it probably doesn't make much difference since the final Altman value is below the critical threshold of 1.8 anyway, but we'd be interested in thoughts/comments on this point.

As per the bottom of page 11 of the Paper, Total Liabilities of -£2.51bn used in T4 are the sum of Current and Long Term Liabilities, i.e. in this case, -£1,514.2m + -£995.8m. Even though this is a negative figure, Altman seems to use a positive ratio (see Table 1: http://pages.stern.nyu.edu/~ealtman/Zscores.pdf). 

Hope that helps. 

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MBS 24th Nov '11 5 of 6

Interesting. Thank you.

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sai lang 19th Sep '18 6 of 6

In reply to post #62219

Very interesting indeed.

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