The rally in the market in response to cuts in tax rates has clearly fizzled out due to expectations of weaker earnings in Q2 FY20 along with global issues. However, a correction has always proved to be an opportune time to buy, and so we went on a search for quality large-cap stocks that may be available cheap.
We started off by gauging the financial health of companies using the following:
The Altman Z-score
The Altman Z-score is a widely used measure that applies an algorithm that has been found to have useful predictive value on the likelihood of a business going bankrupt. Keep in mind that this is a likelihood and not a prediction. From a company's financials, it may look likely that bankruptcy looms, but the management may well succeed in improving matters. Read our detailed note about the Altman Z Score. We decided upon a threshold of 2.99 for this score and of the 62 large-cap companies (excluding banks and finance companies), around 44 qualified.
The Piotroski F-Score is a composite score of financial health, an easy to use single number that gives an overall financial score to a company. Stocks are rated on a score of 0 to nine based on nine parameters, nine being the best. Since the score is based on recent performance, we can say it represents the current financial strength relative to the recent past. Read our detailed note on the Piotroski F-Score. Of the 44 companies that were able to clear our Z-score threshold, only 12 companies managed to clear the F-score threshold set at 7 or above.
Modified C-score is a most interesting measure, and as some investors would say, a most crucial one in India. It measures the likelihood that a company has been dressing its books. When their operational parameters worsen, and the stress starts to show in the financials, a lot of businesses try to be a little creative with their accounts so that investors don't take to their heels. What we have here is a probabilistic score that measures a company's resemblance to other companies where the accounting has been creative. The higher the C-score, the higher is the probability that something is suspect. Read our detailed note on the Modified C-score. Of the 12 companies that were able to clear the two scores above, 10 companies were able to clear the 4-or-below threshold we set out for this score.
Once we established the companies that cleared our exceptionally high standards of quality, we set out to determine if they were actually cheap based on a couple of filters which were:
- Earnings yield (Earnings before Interest and taxes/Enterprise value) should be greater than 5%
- Price earnings growth (Price earnings ratio/ past 5 year compounded growth rate) less than 1.
Even though of the 12 companies, there were 4 that had an earnings yield greater than 5%, namely Gail, Wipro, Sun Pharmaceuticals and Dr Reddys, these 4 companies had significantly higher than 1 price earnings growth ratios. This is the reason why according to our slightly higher standards of quality companies available cheap, no large-cap company could qualify currently. When we ran this story a few months back, Petronet LNG was able to qualify; however this time even though it cleared our filters on being cheap, it was not able to clear all the thresholds we set for the scores where we define quality.
Disclosure: The intent of the article is not to recommend any specific stocks. If you wish to invest in any of the above-mentioned securities, please do thorough research.