One of the keys to success in the markets is reading. Every successful investor and trader that I know is an avid reader -- and I do not mean reading just financial news. I read a lot of books related to non-market subjects, and I usually come away with ideas that apply to both investing and living.
I admit that I am also enough of a geek that I try to read academic papers that have a direct effect on value and distressed investing. These papers are interesting and offer valuable information. Academic studies tend to drill down on one factor or data point, so I find the real value of these papers is to compare and combine the information gathered from several into one body of information.
For example, one of my favorite papers of all time is "Falling Knives Around the World," published by the Brandes Institute. It looks at what happens to large-cap stocks that plunge by 60% in a 12-month period. They found that these stocks, as a group, outperform the comparable indices by a significant amount. However, they also found the bankruptcy rate is very high for these companies and most of these stocks underperform the market for one- and three-year periods after the decline. Also, the group's portfolio outperformance is the result of a handful of stocks that recover and see their stock prices climb far beyond the indices.
The paper is interesting, but it is clear that there are two pitfalls to investing in falling knives. First, avoid companies that will file for bankruptcy protection; this will improve the overall performance of a portfolio of fallen knives. For that, we can turn to the work of Professor Edward Altman of New York University's Stern School of Business. In 1968, Altman published a paper that tested his new bankruptcy and financial health indicator for public corporations, the Z Score. Using a formula that evaluated equity, liabilities, working capital and earnings, Altman's scale gave a value that predicted a company's financial health. Companies with scores below 1.81 were in distress and had a high likelihood of bankruptcy. Between 1.81 and 2.99 was a gray area where scores needed to be rechecked frequently to see if they were improving or deteriorating. A score above 3.0 indicated a financially healthy company.
But the Z Score has one problem when evaluating the health of falling knives: It does not work well with financial companies, so we need a way to measure the financial health of banks and other institutions. Peter Lynch once suggested that the tangible-equity-to-asset ratio as a good indicator of the financial health of a bank. Academics seem to agree, as I have found numerous citations and papers supporting this thesis over the years.
The second issue when putting together a portfolio of falling knives is finding those that outperform the index by a wide margin while avoiding the underperforming stocks. Once again, we can turn to academia to solve this problem. University of Chicago Professor Joseph Piotroski found that the same performance characteristics of falling knives applied to stocks trading below book value. As a whole, a portfolio of stocks trading below book value outperforms the market. However, less than half the individual stocks did so. The outperformance was the result of a select group of stocks that far outperformed the index while the rest were value traps.
Piotroksi developed a measure of nine accounting factors to identify winners. The more accounting tests a company passed, the more likely it was to be a winning stock that outperformed the indices. Companies with a 5.0 or more on the professor's F Scale were likely to provide substantial outperformance.
We can combine these studies into a very effective investing process. Companies that have fallen in price and have a low prospect for financial distress should outperform the market. If we screen further for companies with solid prospects and improving fundamentals, as measured by the F Scale, we should be able to identify those falling knives that will outperform the broader market by a wide margin over time.
This week, I am going to spend some time looking for these stocks and see if I can put together a market-beating portfolio in this difficult market environment.