Beneish M-Score

Beneish M-Score is a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings.

It was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy.

It is based on a combination of the following eight different indices:

1. DSRI = Days’ Sales in Receivables Index
• DSR = Receivable /Sale
• DSR t / DSR t-1
• A  large increase in DSR could be indicative of revenue inflation. 
2. GMI = Gross Margin Index
• Gross Margin = (Sales - COGS)/Sales
• Gross Margin t-1/ Gross Margin t
• Gross margin has deteriorated when this index is above 1.
• A firm with poorer prospects is more likely to manipulate earnings. 
3. AQI = Asset Quality Index
• Asset Quality = Non Current Asset other than PPE / Total Asset
• AQI = AQI t / AQI t-1
• Note: Biological assets is part of PPE for a plantation company. Likewise for land held for development, property development costs, investment property for property companies.
4.  SGI = Sales Growth Index
•  Sales t / Sales t-1
• Sales growth itself is not a measure of manipulation.
• A growth companies are likely to find themsleves under pressure to manipulate in order to keep up appearances
5. DEPI = Depreciation Index
• Rate of Deprecition = Depreciation / (PPE + Depreciation)
• Rate of Deprecition  t-1/ rate of Depreciation t
• > 1 indicates that assets are being depreciated at a slower rate - the firm might be 
• revising useful asset life assumptions upwards
• adopting a new method that is income friendly.
6. SGAI = Sales, General and Administrative expenses Index 
• SGA =  SGA Expenses / Sales
• SGA t / SGA t-1
7. LVGI = Leverage Index 
• Legerage = Total Debt / Total Asset
• Leverage t / Leverage t-1
• > 1 = increase in leverage
8. TATA - Total Accruals to Total Assets 
• Total Accruals = Change in Working Capital Account

 

The Beneish M Score Formula

M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI

The interpretation...

• M Score > -1.78 - a strong likelihood of a firm being a manipulator. 

Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.

The 5 Variable Version of the Beneish Model

• It  excludes SGAI, DEPI and LEVI which were not significant in the original Beneish model.
• M  = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI 

References:-

• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Beneish M Score to Detect Earnings Manipulation, Jae Jun
• M score for earnings manipulation paper 
• Benish M Score, YCharts Financial Glossary
• Buying bargains on the mend kcchongnz (private)

Pitroski F-Score

Embedded in that mix of companies, you have some that are just stellar. Their performance turns around. People become optimistic about the stock, and it really takes off [but] half of the firms languish; they continue to perform poorly and eventually de-list or enter bankruptcy.”
-- Joseph Piotroski, University of Chicago Accounting Professor

Pitroski want weed out the poor performers and identify the winners in advance.

He devised a simple nine-criteria stock-scoring system called the Pitroski F-Score, for evaluating a stock’s financial strength that could be determined using data solely from financial statements as below.

1.  Net Income: Bottom line. Score 1 if last year net income is positive.

1. Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.   

1. Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.  

1. Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.

1. Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)

1. Current Ratio:  Measures increasing working capital. Score 1 if CR has increased from the prior year.    

1. Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.

1. Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.

1. Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

 The interpretation...

• 8 - 9: Strongest Stock

• <= 2 : Weakest Stocks

Pitroski  made clear that the paper "does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms" - rather, it is just one way that investors can use relevant historical information to eliminate firms with poor future prospects from a generic value portfolio.

It is not useful to check stock selected by

• Magic Formula -  buying good companies at good price

• Graham NCAV or NNWC

It will be a useful weapon if you want to 

• listen to some rumours from your remisiers, friends, internet forums of insiders going to pump up the share price (purportedly for your benefits) of some crappy stocks 

• ride on the band wagon on the turnaround stories

 Even that, one must exercise good judgment.

References:-

• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Buying bargains on the mend kcchongnz (private)
• Value Investing: The use of historical financial statement information to separate winners from losers

Finding a Bargain - The "Cigar Butt" Approach

• Finding a bargain is a seductive prospect. And, Warrent Buffett calls this "cigar butt" approach to investing.
• “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit”
• It having a very conservative measure of intrinsic value, essentially liquidation value, and a large margin of safety
• In bull markets it can be arduous
• But, in depressed and volatile conditions like 2009, the basket of potential stock candidates tends to swell. 
• How do you go about finding these kinds of deep value or bargain stocks?
• Pay less than book value 
• Price-to-book on a tangible assets only
• This is only applicable for manufacturing companie
• Service businesses - depends on intagible assets which isn’t even on the balance sheet
•  It may not give enough MOS if fixed assets may have been overvalued. Thus, a number of other (more extreme) metrics can be used by the deep Value Investors…
• Pay less than liquidation value (NCAV)
• Benjamin Graham advocated buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing. 
• He ignoring fixed assets like property and equipment and solely valuing current assets (such as cash, stock and debtors) on the basis that only these assets could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the so called net current asset value.
• To defend against the risk on individual failure, Graham require MOS of about 33% & diversify to at least 30 stocks. 
• In a study by Henry Oppenhemier in the Financial Analysts Journal, the mean return from discounted net current asset stocks over a 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index – an astonishing outperformance.
• Pay even less than liquidation value (‘Net Nets’)
• Graham make allowance on cash due from debtors (as it might not able to collect it) and inventories (as it may have to be discounted).
• Net Net Working Capital = cash and short-term investments + (75% * debtors) + (50% * inventory) – total liabilities.
• Buy companies selling for less than their cash (Negative Enterprise Value)
• Investors can look for companies whose cash is worth more than the total value of their shares plus their long-term debt
• This investment approach is known as buying stocks with a Negative Enterprise Value and waiting for them to be revalued.
• It offer a potential arbitrage opportunity, whereby a buyer of the company could snap up the entire stock and use the cash to pay off the debt and still pocket a profit.
• New opportunities with new lows
• It  was taken by Walter Schloss, another investor that studied under Graham and went on to refine his tutor’s theories into his own strategy.
• It blends the all-important book value with stocks that have fallen to new lows in terms of market price. 
• Schloss saw new lows (e.g. 52W low) as an indicator of a possible bargain stock.
• He stressed the importance of distinguishing between temporary and permanent problems. 
• He would look for companies trading at a price that was less than the book value per share, no long-term debt, stocks where management owned above-average stakes for the sector and, finally, a long financial history.
• Schloss preferred to invest in sectors he understood, particularly old industries like manufacturing
• Schloss believed in significant diversification although his willingness to run up to 100 stocks would have many investors reeling. 
• Over the 45 years from 1956 to 2000, his fund earned an astounding compound return of 15.7%, compared to the market’s return of 11.2% annually over the same period. In the words of Buffett, Schloss “doesn’t worry about whether it’s January…whether it’s Monday…whether it’s an election year. He simply says if a business is worth a dollar and I can buy it for 40 cents, something good may happen”.
• Deep value investing is not an approach for the faint-hearted.
• Bargain Investors would invest in  the most unloved stocks in the market and  that leaves a bargain strategy open to significant risk.
• Investors should always back up their screening with detailed scrutiny as well.
• The original ‘bargain’ price probably will not turn out to be such a steal after all because, 
• “in a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. 
• Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
• How do deep Value Investors mitigate the risk of cockroaches? 
• Diversification - the successes should outweigh the catastrophes. 
• For Graham, the target was upwards of 30 stocks 
• For Schloss, the number could be as heady as 100.

References:-

• Cigar Butts Investing and Diversification kcchongnz (private)

Altman Z-Score

• It is a statistical tool used to measure the likelihood that a company will go bankrupt dvised by Edward Altman, the New York University professor in the 1960s.
• It is a multivariate analysis to the mix of traditional ratio-analysis techniques (e.g. current and quick ratio), and able 
• to consider  the effects of several ratios on the "predictiveness" of his bankruptcy model, 
• to consider how those ratios affected each other's usefulness in the model.
• Altman evaluated 66 companies (half of which had filed for bankruptcy between 1946 and 1965) and started out with 22 ratios classified into five categories (liquidity, profitability, leverage, solvency and activity) but eventually narrowed it down to five ratios.
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = EBIT / Total Assets
• X4 = Market Value of Equity / Book value of Total Liabilities
• X5 = Sales / Total Assets
• Altman re-evaluated his methods by examning 
• 86 distressed companies from 1969 to 1975
• 110 bankrupt companies from 1976 to 1995
• 120 brankrupt companies from 1196 to 1999
• Altman Z-Score, Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5
• X1: Working Capital / Total Assets
• Working capital = current asset - current liabilities 
• Valuable liquidity measure of the net liquid assets of the firm realtive to the total capitalization 
• Liquidity and size characteristics are explicitly considered.
• A firm experiencing consistent operating losses will have shrinking current assets in relation to totla asset
• X2: Retained Earnings / Total Assets
• RE = Total Amount of reinvested earnings / losses of a firm over its entire life.
• The age of firm is implicitly considered in this ratio - a relatively young firm will probably show a low X2 ratio (as it has not enought time to accumulate profit)
• Young firm is discriminated in this analysis? Its chance of going bankrupt is relatively hire than older firm. (this is precisely the situation on the real world)
• It also measure the leverage of the a firm - firm with highe RE relative to TA financed their assets through retention of profits and have not utilized as much debt.
• X3: EBIT / Total Assets
• A firm ultimate existence is based on the earning power of its assets. X3 measure the true productivity of the firm's assets - independent of any tax or leverage factors
• Insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firm's assets with value determined by the earning power of the assets. 
• X4: Market Value of Equity / Book value of Total Liabilities
• Equity = all shares of stock (preferred and commont)
• This measure show how much the firm's assets can decline in value before the liabilities exceed the assets and the firm becomes insolvent.
• It appear to be more effective predictorof bankruptcy than Net Worth / Total Debt [Book value]
• X5: Sales / Total Assets
• It illustrating the sales generating ability of the firm's assets.
• It measure management's capacity in dealing with competitive conditions.
• It is useful predictor when used with the other four.
• The interpretation of Altman Z-Score
•  > 3.0 = The company is "Safe" based on the financial figures only.
• 2.7 - 2.99 = "On Alert" 
• 1.8 - 2.7 = Good chance of the company going bankrupt within 2 yers of operations from the date of financial figure given.
• < 1.8 = Probability of Financial Catastrophe is Very High
• If Z close to or below 3, some serious Due Diligence on the company in question before even considering investing.
• Z Score was between 82% and 94% accurate 
• 'Garbage in, Garbage out' motto applies - if the company financials are misleading or incorrect, Z Score will be, too.

References:-

• Altman Z-Score  kcchongnz (private)
• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Buying bargains on the mend kcchongnz (private) 

Invested Capital and Excess Cash

Eq (1) : Total Equity + Total Debt - Excess Cash - Investments

• Excess Cash = Cash a company has that is not required to operate the business.
• Investments 
• investment in quoted or unquoted shares
• investment in properties (for a non property development company)
• investment in associate companies or JV (which account is not being consolidated into the group's account)
• Why Net out Excess Cash & Investment?
• Interest Income from Cash + Return from investments is not part of operating income.
• Dividing Operating Income by Total Book Value - yield too low for a return on capital for companies with significant cash balances.
• If we add back interest income (from cash) & return from investment to the numerator - it is not a fair measurement as interest income is low risk & low return investment
• Thus, the reason is to be consistent with the use of Operating Income as Earning measurement.

Eq (2) : Total Assets - Non-interest bearing Current Liabilities - Excess Cash - Investments

• Using the book value of assets to replace the book values of debt and equity
• Total equity + total debt in Eq (1)  =  Total Assets – Non-interest bearing Current Liabilities in Eq (2)

Eq (3): Fixed Assets + Current Assets - Non-interest bearing Current Liabilities - Excess Cash - Investments

•  From Eq (2), Total assets = Fixed Assets + Current assets in Eq (3) 

Eq (4): Fixed Assets+ Non Cash /Investment Net Working Capital

Eq (5): Fixed Assets + Receivables + Inventories - Payable

• Fixed asset - PPE, long-term lease payment, investment properties for a property company, biological assets for a plantation company [but not take in all assets ] 
• Other non-current assets, e.g. long-term investment, tax payable, retirement benefits etc - it is not a invested capital in their real sense (It is arguable). 
• Other current assets, e.g. tax credit, etc is removed.
• Other current liabilities, e.g.  tax payable, dividend payable etc not consider as part of the working capital.
• Accounts payable - subtract it from IC is because it represents capital invested in the business by a company’s suppliers or contractors, not the company itself.  
• If you use Eq (2), you are unknowingly taken them as part of the IC which is why it is different from if you use Eq (5). 
• Eq (5) is what Greenblatt used in his magic Formula.

Excess Cash

• Company carry some cash and equivalents to meet short-term obligations, pay dividends, buy back stock, make acquisitions, etc. 
• It may carry short-term investments, such as money market fund. 
• Both of them can be grouped together and call it "Cash".
• Invested capital is a firm's physical plant, receivables, inventory, and so forth.
• Cash isn't really invested capital used to generate the company's revenues and profits. It should be subtracted out when calculate the Invested capital. 
• Cash acts as a discount on the purchase price of the company. E.g. pay $1B to buy company with $250M cash in bank (and no debt) - in essence, you are only paying $750M  -- This is why we subtract cash out from the enterprise value.
• Excess Cash = Cash is not required to met short term obligations which are listed in current liabilities. 
• Excess Cash = Cash - Total Current Liabilites
• But, we might able to use the current asset to cover the current liabilities instead of using cash only
• Excess Cash = (Cash - Current Liabilites) + (Current Asset - Cash)
• While, Excess Cash shouldn't > Cash 
• Excess Cash = Cash - Max[0, {CL - (CA - Cash}]
• TEV = Market Capitalization +Total Debt + Minority Interest - Excess Cash --> We have already added all "Debts" in the equation as total debts. If we were to consider this "debt" in the "excess cash" term and hence get a negative "excess cash", the EV will be jacked up higher.  
• Excess Cash = Cash - Max[0, {(CL - Short Term Debt) - (CA - Cash}]
• For a company has too much current liabilities, it might have a deficit of cash - it need to find cash from somewhere (right issues? borrowing? etc... to meet short term obligation) --> and, ultimately this would increase invested capital, and increase the enterprise value.

References:-

• What is invested capital and excess cash and how to estimate them kcchongz (private)

Money Management with Kelly %

Money Management System can answer following questions:-

• How much money do we put in each stock? 
• When do we buy or sell those stocks?

How to get Kelly %?

• Access your last 50-60 trades.
• Calculate
• Win Probability, W = Number of trades with +ve return  / Total number of trades
• Win/loss ratio, R =  Average gain of +Ve Trade / Average loss or -Ve  
• Kelly % = W – [(1 – W) / R]

How to Interprete Kelly %?

• Kelly % represents the size of the positions you should be taking. 
• It lets you know how much you should diversify.
• Regardless of what kelly %,  not to commit >= 20-25% of your capital to one equity.  Allocating any more than this is carries far more risk than most people should be taking. 

The Bottom Line

• It will help you to diversify your portfolio efficiently, but there are many things that it can't do.  
• It cannot pick winning stocks for you.
• It cannot ensure that you always make spectacular returns
• But, it can help you limit your losses and maximize your gains through efficient diversification.
• Also, there is always a certain amount of "luck" or randomness in the markets, which can alter your returns.  

References:-

• Money Management Using The Kelly Criterion By Justin Kuepper

14 Characteristics of Crappy Stocks from kcchongnz

[1]. Loss-making companies and mostly companies in a bad shape.

E.g. MTDACPI - losses almost every year and ballooning debts.  

[2]. Cheap penny stocks; price < 50 sen  which drop from higher price (RM1 or RM5) due to high losses every year.

E.g. MAS

[3]. Low NTA (Net Tangible Assets) per share. Poor quality assets - little value & don't generate much income.
E.g. AMEDIA

[4]. High gearing and high debts. High risk - high chance they could not service the debts.
E.g. KNM - 1B debt, little or no profit/positive cash flow.

[5]. Stay flat when market goes up, goes down even fasterwhne stock market goes down.

E.g. COMPUGT  

[6]. Generous director fees, allowances and bonuses irrespective of the losses of the company.

E.g. SMTRACK  

[7]. No Dividend - irrespective of profit/(loss) of the company.

 

[8]. Target of stock market syndicates
E.g. GLOTEC, SUMATEC, HUBLINE, PDZ.

[9]. Juicy stories and Market rumours - created by the stock syndicates to entice retail investors
E.g. HIBISCS - plenty of MOU, magic touch of Dr Kenneth

[10]. They are usually speculative stocks; they can go very high up within a short time frame. 
E.g. SUMATEC

[11]. Always ask for money - every few years there is a rights issue or private placement.
E.g. LONBISC

[12]. Crappy management - playing company stocks for profit rather than running the company for a profit, selling their assets to the company at high valuations, approving stock options to themselves.

E.g. MPCORP

[13]. Heavily promoted in stock market forums, stock market magazines, newspapers and even Facebook stock groups. A good story.......
E.g. SUMATEC. GLOTEC, KNM, HUBLINE, PDZ. 

14. Red chip companies
E.g. CSL, HBGLOB, CAP, XDL, CHOUHUA
 

References:-

• 14 Characteristics of Crappy Stocks kcchongnz (private)