Tag Archives: etf

The Altman Z-Score After 50 Years: Use And Misuse

By Larry Cao, CFA This is the second installment in my interview series with Edward Altman in which we discuss the most advisable and problematic applications of the Altman Z-score. For additional details of our conversation, check out the first installment. Larry Cao, CFA: It’s been almost 50 years since the Z-score was first developed. Would you suggest doing anything differently today? Edward Altman: Over the years, the so-called cutoff scores in the model has been retained by the people who applied the model. But in my opinion, that is not the best thing to do. Over time, I began to observe that the average Z-score of American companies mainly, but even global companies, began to get lower and lower. [The bond market] became more available for both investment grade and non-investment grade companies and companies periodically took advantage of low interest rates to raise their leverage. As a result, the financial risk of companies began to increase. Also with global competition, companies’ profitability began to diminish. And so the average Z-score became lower and lower, which meant that more firms would have been classified as likely bankrupt using the Z model if we kept the original cutoff scores. In order to modernize the model, we needed bond-rating equivalence of the scores, which changes constantly and adds on an updated nature to the interpretations of the scores. We now think the most important attribute of the Z model is the probability of default (PD), not the zone classification – safe, grey, or distress. We do it in a two-step process. We get the PD from the score of the company, whether it be from Z, or Z prime, or Z double prime. And then we look at the bond rating equivalent as of that point in time. For example, 2015 – the average B-rate company has a Z-score [of] about 1.6. That would be in a distress zone back in 1968. But today, B is a very common bond rating for many companies. In fact, globally it’s probably [the] most dominant junk rating category. If you rated all companies in the world, the average would probably be about B if they had a rating. And so we ascribe a probability of default based on a bond rating equivalent by looking at the historic incidence of default given a B rating at birth. Cumulatively, I can tell you, from one to 10 years, what the likelihood of default is given a bond rating equivalent. So no longer do we only look at the cutoff scores for the three zones of credit worthiness. Okay, bond rating equivalent is in and cutoff scores are out. What mistakes do you see practitioners making in using the Z-score today? To this date, I would say the vast majority of people are misusing the Z-score because they are applying it across the board regardless of the sector, the industry. And what we found over the years is that non-manufacturers, especially in certain industries like services or retail, have on average higher Z-scores than manufacturing companies. My advice for users is if you are outside the United States, and particularly if you are not a manufacturer, you should look at Z” and its bond rating equivalence approach for ascertaining a PD. Would you say the value of the Z-score is more in its methodology or the score itself? That’s a great question, Larry. Yes, I’ve always argued it’s better to use a local model rather than the original US model. And I’ve done it myself. I’ve personally built models in Brazil, Australia, France, Italy, and Canada. And you will find references to models almost anywhere in the world in the literature. It’s a pretty easy methodology for Ph.D students and practitioners to adapt to a different environment. But then again, even if it isn’t the best model that could be built for service companies or energy companies in 2016, it’s still a good benchmark and has retained its accuracy. If I had the time, I would build the model for Malaysian companies or Indonesian companies or Hong Kong companies or Asia all together. I suppose that there are good researchers there who might just attempt that! Will there be a data issue? For a lot of these countries, the history may not be there. They don’t have bond rating equivalence. That’s exactly right. That’s a very good point. The bond rating equivalence in almost all cases has to be derived from data from the United States. We have lots of defaults, lots of bankruptcies in the US, so you can get probability distributions based on ratings that have a fairly large sample. You can’t do that in emerging markets or countries like Australia, where they haven’t had a recession since the early 1990s. So yes, people said I should have continually updated the Z model but that means you have to keep publishing the updates. People have to find it. People have to use it and test it. It’s much easier to just periodically test the model, and to even build new models that incorporate the lot of data from the relevant countries and industries and combine this firm data with market value measures and possibly even macroeconomic data. What advice do you have for practitioners who want to build their own version of the Z-score model? For example, what’s your secret sauce for putting together the sample? Although the methodology is pretty straightforward, there are subtleties to it. You need a sample of healthy companies and unhealthy companies. There are issues such as sample size. Should [there] be [an] equal number in the two groups or should there be more representatives of the population – 99% non-default, 1%, 2%, or 3% default, depending on the time period? Should they all be manufacturers? Should they be a cross section of industries? Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Investment Wisdom From The Original Global Guru

Sir John Templeton, who passed away at the age of 95 in 2008, was the original Global Guru. Templeton provided me with an introduction to the world of global investing when I picked up a book on Templeton’s investment philosophy many years ago in Amsterdam. While today you can buy a Brazilian or Malaysian or South African stock with a click of the mouse, the world was a very different place when Templeton began his global investing career. John Templeton: A Pioneer in Global Investing Born in 1912, Templeton hailed from the South (Winchester, Tennessee), graduated from Yale in 1934 and won a Rhodes Scholarship to Oxford. After studying law in England, Templeton embarked on a whirlwind grand tour of the world that took him to 35 countries in seven months. That tour exposed him to the enormous investment opportunities that exist outside of the United States. In the very first display of his famous contrarian streak, Templeton came to Wall Street during the depths of the Great Depression to start his investment career in 1937. Templeton soon borrowed a then-princely sum of $10,000 ($170,000 in today’s dollars) as a 26-year-old investor and bought shares of 104 European companies trading at $1 per share or less. This was in 1939, the year German tanks rumbled into Poland, launching World War II. Though dozens of companies were already in bankruptcy, only four companies out of those 104 turned out to be worthless. Templeton held on to each stock for an average of four years and made a small fortune. In 1940, he bought a small investment firm that became the early foundation of his empire. Templeton then went on to build an investment management business whose name became synonymous with value-oriented global investing. He launched the Templeton Growth Fund in 1954 – notably in Canada, which then had no capital gains tax. He made his company public in 1959 when it only had five funds and $66 million under management, and eventually sold his business to Franklin Resources for $913 million in 1992. Templeton focused his final years largely on philanthropy, endowing the Centre for Management Studies at Oxford. He also established the Templeton Prize in 1972, which recognized achievement in work related to science, philosophy and spirituality. His Templeton Foundation, which today boasts an endowment of $1.5 billion, distributes $70 million annually in grants to study “what scientists and philosophers call the Big Questions.” Past winners have included Mother Theresa, Billy Graham, Desmond Tutu and the Dalai Lama. John Templeton: Contrarian to the Core Templeton’s investment track record was impressive, although, given his deeply contrarian style, inevitably quite volatile. A $10,000 investment in the Templeton Growth Fund in 1954 grew to roughly $2 million, with dividends reinvested, by 1992. That works out to a 14.5% annualized return since its inception. Templeton was perhaps best known for investing in Japan in the 1950s when “Made in Japan” was synonymous with free toy trinkets found in cereal boxes. And like all great investors, Templeton was not afraid of big bets. At one point in the 1960s, Templeton held more than 60% of the Templeton Growth Fund’s assets in Japan. That kind of a concentrated position in a global fund would be illegal on Wall Street today. But Templeton also had the savvy to exit markets when they were overvalued, selling out of Japan well before the market collapsed in 1989. Central to Templeton’s investment philosophy was buying superior stocks at cheap price points of “maximum pessimism.” He diligently applied this approach across a range of countries, industries and companies. As Templeton noted in an interview in Forbes in 1988: “People are always asking me where the outlook is good, but that’s the wrong question. The right question is, ‘Where is the outlook most miserable?’ ” My favorite Templeton anecdote was his bet against the U.S. dotcom bubble in 1999. Templeton famously predicted that 90% of the new Internet companies would be bankrupt within five years, and he very publicly shorted the U.S. tech sector. I think it’s a terrific irony that John Templeton – a value investor known for sussing out little known global opportunities – made his quickest and possibly biggest fortune by shorting U.S. stocks. John Templeton: Lessons for Today’s Market With most global stock markets trading in bear market territory, you may find some comfort in John Templeton’s most famous piece of advice: ” To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward .” This advice is simple – but not easy to implement. Templeton also added a small refinement to this approach. He recommended that you initially take a small position in your investment ideas before rushing in. If it’s a truly great bargain, there’s no need to hurry. Finally, what I found most refreshing about John Templeton is his relentless optimism. Templeton once asked a journalist to write about why the Dow Jones Industrial Average might rise to one million by the year 2100. At first blush, “Dow 1,000,000” sounds absurd. Yet, it turns out that thanks to the miracle of compound interest, the Dow would only need to rise about 5% per year to hit that level in 86 years.

5 ETFs For Portfolio Safety, Stability And Diversification

Global stock market volatility, oil price collapse and economic slowdown in China continue to rattle investor confidence this year. Former high flying stocks have come back to earth in the past few weeks as investors worry about the impact of weak global demand on corporate earnings. Investors had poured a lot of money into these stocks despite their sky high valuations but “risk-off” sentiment is sending many to “safer” assets now. As the domestic economy continued to recover slowly but steadily over the past few years, US stocks remained one of the best asset classes in the world. But of late, domestic economic growth has been rather uneven. In the current uncertain market environment, it would be better for investors to focus on capital preservation. Below we have discussed some ETFs that will not only provide stability and diversification to your portfolio but also help in capital preservation. Long-Term Treasury Bonds The Federal Reserve spent the last year prepping the markets for a rate hike for the first time in almost a decade and ultimately raised rates by 25 bps in December and also penciled in four rate hikes this year. The market however expects not more than one rate increase this year. So, bond markets continue to frustrate bears again. Longer-term bonds are impacted more by inflationary expectations than by monetary actions and with expectations so muted, the bullish trend for these ETFs is likely to continue. Then while rates are low here in the US, they are much lower in the other parts of the developed world. In Europe and Japan, monetary authorities are expected to continue easing in order to fight deflationary risks. So, compared with those interest rates, US interest rates are still very attractive for foreign investors. 25+ Year Zero Coupon U.S. Treasury Index Fund (NYSEARCA: ZROZ ) ZROZ follows the BofA Merrill Lynch Long US Treasury Principal STRIPS Index, which focuses on Treasury principal STRIPS that have 25 years or more remaining to final maturity. It charges just 15 basis points in expenses while the 30-day SEC yield is 2.53% currently. iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) TLT tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index. It is the most popular and liquid ETF in the space with AUM of over $9.4 billion and excellent daily trading volumes. The fund charges 15 bps in expense ratio while the 30-day SEC yield is 2.34% currently. Both these ETFs have Zacks ETF Rank #2 (Buy). Gold On Monday, gold recorded its biggest daily gain in more than 14 months as a strong risk-off sentiment continues to force investors to pile into the safety of the precious metal. Additionally, a falling dollar (commodity prices generally move inversely to the dollar) and rising demand in China and India-the two biggest consumers of gold in the world-have also been helping gold’s ascent. Chinese investors in particular have been buying gold lately as the country’s stock market and currency continue to swoon. Negative interest rates in some of the major countries are also boosting gold prices. Gold critics often argue that the “barbarous relic” is an unproductive asset since it pays nothing to holders and that argument does make some sense when interest rates are high but not in the ultra-low/negative interest rate environment. iShares Gold Trust (NYSEARCA: IAU ) IAU provides a convenient and cost-effective access to physical gold. It is a physically backed ETF with more than $5.2 billion in assets. The fund has beta of -0.23 with the S&P 500 index and adds diversification benefits to an equity focused portfolio. SPDR Gold Trust ETF (NYSEARCA: GLD ) GLD is the most popular gold ETF with almost $29 billion in AUM and excellent trading volumes. It is a physically backed ETF that charges 40 basis points in annual expenses. While IAU has a lower fee, GLD’s excellent trading volumes make its trading very cheap. So, IAU is more suitable for buy and hold investors while GLD is better for trading portfolios. Municipal Bonds Municipal bonds were one of the best performing asset class in the US fixed income space last year. There are many factors that suggest that they may continue to outperform this year as well, including decreasing supply, rising tax rates and juicy income yields in the current ultra-low rate environment. Municipal bonds supply as of the end of last year was about $400 billion , boosted mainly by refunding issuances in anticipation of higher interest rates. Experts expect the supply to decrease by about 25% this year. iShares Muni Bond ETF (NYSEARCA: MUB ) MUB is the most popular ETF in the municipal bond space with more than $6.1 billion in AUM. It charges 25 bps in expenses and has a 12-month yield of 2.49%. The income is exempt from federal taxes and the Alternative Minimum Tax (AMT). The product provides a convenient access to more than 2000 investment grade municipal bonds. The Bottom-Line During times of turmoil, it is most important for investors to stay focused on their longer-term investing goals. Further, it is beneficial to stay diversified as history has shown us diversified portfolios always have better risk-adjusted returns over longer periods. Original post