{"id":4177,"date":"2020-02-11T10:43:12","date_gmt":"2020-02-11T09:43:12","guid":{"rendered":"https:\/\/neu.hqam.ch\/the-magic-of-z-and-why-fundamentals-still-matter\/"},"modified":"2023-06-12T10:48:44","modified_gmt":"2023-06-12T08:48:44","slug":"the-magic-of-z-and-why-fundamentals-still-matter","status":"publish","type":"post","link":"https:\/\/hqam.ch\/en\/the-magic-of-z-and-why-fundamentals-still-matter\/","title":{"rendered":"The magic of \u201cZ\u201d and why fundamentals still matter"},"content":{"rendered":"\t\t
\n\t\t\t\t\t\t
\n\t\t\t\t\t\t
\n\t\t\t\t\t
\n\t\t\t
\n\t\t\t\t\t\t
\n\t\t\t\t
\n\t\t\t\t\t\t\t\t\t

Fatal Attraction<\/strong><\/p>\n

Did you know that there are over 630 different meat-eating, flowering plants in the world? Like pitchers, for example, that trap insects, frogs and even mice. They attract their prey with the sweet nectar and juicy flesh that looks like a perfect food for the victim. How is it relevant in the context of equity investing? Extremely, and now more than ever. <\/p>\n

Given a mind-blowing global stock markets rally of 2019 that seem to be transposed into 2020 as well (even coronavirus outbreak was not enough to stop this train), there are many people out there that stayed on the sidelines after Q4\u201918 meltdown and now are in a rush to catch the last train, driven by blinding fear of \u201cmissing out\u201d. This elevated sense of greed cancels out all other alarming noises, from overstretched valuations to weaker economic growth and constrains the ability of thinking straight. FED\u2019s eagerness to continue injecting liquidity in the market and ECB\u2019s lightweight monetary policy only makes the whole situation even more complex and twisted. Does it mean you have to stay from equities for the time being? Not at all. Rather, it means that if you want retirement plan to succeed (or whatever other investment purpose you have), you have to be prudent, consistent and what is even more important \u2013 extremely selective. And never ignore fundamentals, because they do tell a story and will most certainly be helpful in avoiding \u201cthe pitchers\u201d <\/p>\n

Thomas Cook: who could have known?<\/strong><\/p>\n

With \u201cexcellent progress\u201d on US-China trade truce and uncertainty over fate of Brexit congesting the news flow in 2019, the fact that preceding year was rather eventful on bankruptcies could well have been overlooked \u2013 once dearly loved Forever21, PG&E and Thomas Cook (TC) to mention a few. Collapse of the latter came as a shock, especially to the holidaymakers and employees. However, if one studies TC\u2019s fundamentals and balance sheet structure, unexpected turns into something rather inevitable. <\/p>\n

Fig. 1: Extract of Financial Condition Check for Thomas Cook <\/em><\/p>\n

\"\"<\/p>\n

Source: H\u00e9rens Quality Asset Management, Reuters<\/em><\/p>\n

With goodwill accounting for a lump sum of the balance sheet (39%), humungous leverage (24.04) and virtually no return on capital despite equity ratio barely reaching 5%, Thomas Cook really did not need much of additional pressure to collapse like a straw house. When Thomas Cook collapsed, it was bearing \u00a31.6 bn in debt, had negative operating cash flows and its\u2019s Altman Z-Score was barely hovering above \u201c1\u201d. Curious is the fact that eight years ago company escaped insolvency by a whisker and in 2013 have had real struggle with borrowing capability. Group of banks, led by Royal Bank of Scotland, and fundraising from shareholders saved them then in the first and in the second instance. <\/p>\n

The Magic of \u201cZ\u201d<\/strong><\/p>\n

It is commonly perceived that a Z-Score above 2.99 puts a company in a \u201csafe zone\u201d, while that below 1.88 (so-called \u201cdistress zone\u201d) indicates that high probability of a bankruptcy within next two years.<\/p>\n

Range between 1.88 and 2.99 is therefore considered to be a \u201cgrey zone\u201d (1). Despite that E.I.Altman came up with this formula over 60 years ago, it remains one of the best red flags for insolvency. Looking at American and European equities, one can\u2019t help but notice that while both in Europe and US around the same percent of companies fall into \u201cdistress zone\u201d (close to 1\/3 of the universe), latter has substantially larger share of stocks seeing this indicator deteriorate over last 5 years (61.7% vs 53.5%).<\/p>\n

Fig. 2: \u201cZones\u201d and 5y dynamics of Z-Scores for S&P 500 and Stoxx 600 <\/em><\/p>\n

\"\"<\/p>\n

Source: H\u00e9rens Quality Asset Management, Reuters<\/em><\/p>\n

Also sector-wise there is a significant difference \u2013 in Europe, majority of companies with a Z-score below 1.88 are found in Industrial (19.6%), Real Estate (17.4%) and Communication (15.2%) sectors, while in US these are Utilities (29.3%), Discretionary (20.7%) and Energy (10.9%) stocks.<\/p>\n

All levered up<\/strong><\/p>\n

Greater deterioration in Z-Score in US should not come as a surprise, given the quantity of additional debt and the speed at which domestic stocks have been accumulating it. According to Washington Post, US corporations are sitting on $10.1 trillion in corporate debt that is equivalent of 47% of GDP \u2013 a record number since the financial crisis and they have issued $1.2 trillion in last 2 years alone. Alarming is the fact that in Nov\u201919 report, Fed stressed out that the riskiest companies accounted for a bulk of rising debt in recent years and BBB- rated bonds (lowest investment grade) now account for more than 50% of the market (2). When things go down (and they finally and inevitably will one day), guess who\u2019ll turn into nothing but a sitting duck? Therefore, one needs to pick up good cherries, leaving rotting ones behind and fundamentals might well be one\u2019s best assistant. They\u2019ll be as useful in spotting \u201czombies\u201d (link) as they will in pointing out quality investments with strong balance sheets and resilient business models. <\/p>\n

Fig. 3: Median Z-Score and Leverage for Quality Companies and respective Benchmarks (as of 31.12.2019) <\/em><\/p>\n

\"\"<\/p>\n

Source: H\u00e9rens Quality Asset Management, Reuters<\/em><\/p>\n

It does not mean that a quality company cannot fail and turn into an unfortunate investment, but the chances that it will are significantly lowered. And when uncertainty looms, perhaps quality is a good place to sit back and wait for the storm to pass. <\/p>\n\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

\n\t\t\t\t
\n\t\t\t\t\t\t\t\t\t
\n\t\t\t\t\t\n\t\t\t\t\t\t\n\t\t\t\t\t\t\t\t\tView article as PDF<\/span>\n\t\t\t\t\t<\/span>\n\t\t\t\t\t<\/a>\n\t\t\t\t<\/div>\n\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
\n\t\t\t\t
\n\t\t\t\t\t\t\t\t\t

References<\/p>\n

    \n
  1. Altman, Edward I. (September 1968). \u201cFinancial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy\u201d. Journal of Finance: 189\u2013209<\/li>\n
  2. Board of Governors of the Federal Reserve System (November 2019). \u201cFinancial Stability Report\u201d, available at https:\/\/www.federalreserve.gov\/publications\/2019-november-financialstability-report-borrowing.htm<\/li>\n<\/ol>\n\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t<\/div>\n\t\t","protected":false},"excerpt":{"rendered":"

    Fatal Attraction Did you know that there are over 630 different meat-eating, flowering plants in the world? Like pitchers, for example, that trap insects, frogs and even mice. They attract their prey with the sweet nectar and juicy flesh that looks like a perfect food for the victim. How is it relevant in the context […]<\/p>\n","protected":false},"author":1,"featured_media":3894,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"site-sidebar-layout":"default","site-content-layout":"default","ast-site-content-layout":"default","site-content-style":"default","site-sidebar-style":"default","ast-global-header-display":"","ast-banner-title-visibility":"","ast-main-header-display":"","ast-hfb-above-header-display":"","ast-hfb-below-header-display":"","ast-hfb-mobile-header-display":"","site-post-title":"","ast-breadcrumbs-content":"","ast-featured-img":"","footer-sml-layout":"","ast-disable-related-posts":"","theme-transparent-header-meta":"default","adv-header-id-meta":"","stick-header-meta":"","header-above-stick-meta":"","header-main-stick-meta":"","header-below-stick-meta":"","astra-migrate-meta-layouts":"default","ast-page-background-enabled":"default","ast-page-background-meta":{"desktop":{"background-color":"var(--ast-global-color-4)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"ast-content-background-meta":{"desktop":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"footnotes":""},"categories":[37],"tags":[],"class_list":["post-4177","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-corporate-excellence-insights-en"],"acf":[],"_links":{"self":[{"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/posts\/4177","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/comments?post=4177"}],"version-history":[{"count":1,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/posts\/4177\/revisions"}],"predecessor-version":[{"id":4178,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/posts\/4177\/revisions\/4178"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/media\/3894"}],"wp:attachment":[{"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/media?parent=4177"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/categories?post=4177"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/hqam.ch\/en\/wp-json\/wp\/v2\/tags?post=4177"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}