Legendary stock trader Paul Tudor Jones once said: “At the end of the day, the most important thing is how good are you at risk control."
Yet it is all too easy to get carried away with the future prospects of a company without paying enough attention to the boring reality of how its finances shape up today. A solid grasp of risk and prudent risk management policies are often what separates a good investor from a great one.
Luckily it is not as hard as you might think to upgrade your risk management systems. Simple checklists can make for surprisingly effective screens. For example, one of the most famous balance sheet checklists was found to be:
- 72% accurate in predicting bankruptcy two years prior to the event in its initial test, and
- 80-90% accurate in predicting bankruptcy one year before the event in the 31 years up until 1999
These results are for the Altman Z-Score, which measures the degree to which a stock resembles companies that have gone out of business in the past. Steering clear of this type of stock could save us a lot of pain in the long run.
What it says about Personal Products industry operator Reckitt Benckiser (LON:RB.) might well be keeping the group’s chief financial officer, Adrian Hennah , up at night...
Does (LON:RB.) pass the Altman Z-score test?
The Altman Z-Score was developed by New York University finance professor and leading academic, Edward I. Altman. In 1968, the celebrated professor struck upon a combination of five weighted business ratios that is used by investment managers and hedge funds to this day.
Interpreting the Z-Score is simple. Any Z-Score above 2.99 is considered to be a safe company, while those with a Z-Score of less than 1.8 have been shown to have a significant risk of financial distress within two years.
If we apply it to (LON:RB.) what do we get? A Z-Score of 1.72 - well below the cut-off point that signals potential distress.
Using the Z-Score to protect your portfolio
The Z-Score has proven very effective in predicting business distress. It measures how closely a firm resembles other firms that have filed for bankruptcy by looking for red flags in the following areas:
- Current assets as a proportion of total assets,
- Cumulative profitability and use of leverage,
- Productivity of assets, and
- Firm value compared to liabilities
Steering clear of stocks that fail these checks means you are avoiding companies that exhibit similar financial characteristics to companies that have gone bankrupt in the past, often as a result of having a weak balance sheet.
Fund manager Anthony Bolton once said: "When I analysed the stocks that have lost me the most money, about two-thirds of the time it was due to weak balance sheets. You have to have your eyes open to the fact that if you are buying a company with a weak balance sheet and something changes, then that’s when you are going to be most exposed as a shareholder." Using the Z-Score to identify this type of stock seems like a smart way to avoid similar mistakes.
Reckitt Benckiser's weak Z-Score should serve as a reminder to investors to be aware of the risks they allow into their portfolios.
Fortify your portfolio with simple, effective tools
The problem areas for Reckitt Benckiser identified here can be explored in more depth on Stockopedia's research platform. All the best investors have stringent due diligence processes that reduce the chances of them suffering big losses, so why not take a leaf out of their book?
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