New study re-writes the A-Z of value investing

Investors looking to profit during a recession should be targeting stocks with strong fundamentals, according to research by Morgan Stanley.

This “value investing” approach – buying into companies where fundamental measures, such as book value and earnings, are not yet reflected in their share prices – is not new. But Morgan Stanley’s analysis has found that the ability of this approach to deliver returns in downturns depends on the financial strength of the companies – in particular, the importance attached to the balance sheet by investors.

“If a stock’s balance sheet is weak, the valuation multiple will be of little importance at this stage in the economic cycle,” says Graham Secker, Morgan Stanley strategy analyst.

He ranked a basket of European companies by their Altman Z-score – a measure of financial strength devised by US academic Edward Altman (see box). A Z-score can be calculated for all non-financial companies and the lower the score, the greater the risk of the company falling into financial distress.

When Secker compared the companies’ Z-scores with their share price movements, he discovered that the companies with weaker balance sheets underperformed the market more than two thirds of the time.

Morgan Stanley also found that a company with an Altman Z-score of less than 1 tends to underperform the wider market by more than 4 per cent over the year with an associated probability of 72 per cent.

‘‘Given the poor performance over the last year by stocks with a low Altman Z-score, the results of our backtest are now even more compelling than they were 12 months ago,” argues Secker. “We calculate that the median stock with an Altman Z-score of 1 or less has underperformed the wider market by 5-6 per cent per annum between 1990 and 2008.”

Secker sees this as logical. In a recession, companies with balance sheets that are perceived to be weak are deemed a higher risk by lenders and face a higher cost of capital. This turns market sentiment against them and will generally lead to their share prices falling below their peers.

In 2008, the share price performance for stocks with an Altman Z-score of less than 1 was the worst since Morgan Stanley’s analysis began in 1991. Under the Morgan Stanley methodology, the 2008 score is calculated using 2007 company financials. Of all the companies with a 2008 Z-score of less than 1, the median share price performance was a loss of 49 per cent, compared with a wider market fall of 42 per cent.

When compound annual growth rates since 1991 are analysed, the results are more dramatic. On average, companies with Z-scores of less than 1 saw their shares fall 4.4 per cent, compared with an average rise of 1.3 per cent for their peers.

In only five of the last 18 years has a stock with an Altman score of 1 or less outperformed the market. These were generally years of strong economic growth.

However, companies with the highest Z-scores aren’t necessarily the best performers. During the bear market of 2000 to 2002, companies that had a Z-score above 3 fell almost twice as much as the market.

Analysts say the 2009 Z-scores, based on 2008 balance sheets, are far lower than in previous years as companies absorb the strain of the downturn in their accounts. “There’s been a lot of change between 2007 and 2008 [accounting years], tightening of credit and a vast deterioration in corporate balance sheets” says Secker. “I’d expect 2009 [Z-scores] to be much worse.”

Analysis by the Financial Times and Capital IQ, the data provider, corroborates this – showing that the 2009 scores have been badly affected by the crisis.

Some 8 per cent of global companies with a market capitalisation of more than $500m have Altman scores below 1 for 2009 – based on 2008 company financials. This is the highest percentage since 2002 and the largest annual increase since 2001 – showing the impact of the recession on the balance sheets of even the largest companies. If smaller companies were included, the results would be worse – as their earnings and market capitalisations have been affected far more.

European balance sheets were hit the hardest, with companies averaging a Z-score of 2.8, compared with 4.0 for Asia and the US, according to Capital IQ. This suggests the scores are not due to chance. A similar differential was recorded in 2001 during the last recession. On this evidence, US companies appear more resilient than their global peers in a downturn.

On a sector basis, healthcare and IT companies have the highest Z-scores. In 2008, their scores were more than three times higher than the average for the lowest scoring sector: utilities. A similar pattern was found in 2001 – suggesting that investors may want to think twice before buying into “defensive” utilities in a downturn.