In my last post (Calculating the Altman Z Score ^{[1]}), I talked about what Altman Z score is, showed you how to calculated it manually, and how to find it using Stock Rover. Additionally, I went through how to interpret the score (higher is better, over 3 is good) and what Z score trends tell us about the financial health of company over time.

In this post, I will introduce you to a screener I created, called the Increasing Altman Z Score Screener, which filters for stocks with a rising Altman Z score. I will then compare its results to those of our other screeners. After that I will run an experiment to see if we would have been able to predict the performance of stocks—the stocks from our screener—5 years ago.

Contents

- Let Us Begin
^{[2]} - An Altman Z Experiment
^{[3]} - Discussion of Results
^{[4]} - Candidates for Further Research
^{[5]} - Summing It Up
^{[6]}

### Let Us Begin

Running a simple Z score screener with only one criterion—companies with a current Altman Z score above 3—yields 2,459 tickers (at the time of writing). While it’s great that so many companies pass this financial health test, we need to further narrow our search criteria to make it a list we can work with. In addition to the current Z score being greater than 3, I constricted the screener to only include companies that had a current Z score above 3 and have a current Z score greater than last year’s Z score. That reduces the number of tickers to 1,035 but that is still too many companies to consider. My final criteria tightened the criteria to look only for companies that have had an increasing Z score every year for the past 5 years and whose current Z score is above 3. Additionally, I restricted the screener to US companies trading on the NASDAQ and NYSE. This is the Increasing Altman Z Score Screener, and you can download it for yourself from our Library ^{[7]}. The criteria in Stock Rover look like this:

At the time of writing, the screener yielded the following 41 tickers, sorted by market cap. Some companies have both preferred and common stock thus they appear twice. Going forward, I will remove the preferred shares and thus reduce the list to 39 stocks.

How does this screener perform when compared against the major benchmarks over the last five years? The Increasing Altman Z Score Screener is in blue, the NASDAQ is in purple, the DJIA is in black and the S&P 500 is in red.

That is very impressive! Altman was onto something. With the NASDAQ (which is the best performing index over the 5 year period) set as the baseline, I charted the Increasing Altman Z Score Screener against our Small Cap Rockets and Small Cap Growth screeners. After all, such notable returns are normally only seen in small caps. Can the Increasing Altman Z Score Screener results beat high-performing small caps?

Yes. Above, the Increasing Altman Z Score Screener is in blue, the Small Caps Rockets Screener is in orange, the Small Cap Growth Screener is in green and the NASDAQ as the baseline is in purple. Over the last five years, the Altman Increasing Z score Screener beat the Small Cap Rockets by 173% but was outperformed by 253% by the Small Cap Growth. Does not this sound too good to be true? Am I saying you should just run my screener, invest in the stocks that pass and sit back and watch the mega-returns roll in?

If only! Remember, what we are seeing above is the performance of those companies that currently pass my highly restrictive screener today. Hindsight is 20/20 after all, and running my screener 5 years ago would not have produced this same list of stocks. And there are a lot of factors that account for a company’s success that the Altman Z score does not capture. As any smart fundamental investor would tell you, the Altman Z score is only one metric and its trend alone cannot be used as the basis for investing in a stock.

Still, the screener results do illustrate something powerful. Companies with a consistently increasing Altman Z score collectively show strong historical price performance.

### An Altman Z Experiment

To investigate whether we could have been able to predict the outcomes of these 39 stocks five years ago based on the Z score, I went back six to eight years and tried to see if these companies would pass a minimal version of the Increasing Altman Z Score Screener criteria—the Z score in year 5 (i.e., 5 years ago) should have been greater than 3, with a rising Z-score trend for the previous 3 years (i.e. 6, 7, and 8 years ago). Essentially, I was trying to see which companies were in good financial health 5 years ago, and whether their financial health was improving over the 3 years prior to year 5. I did this manually, by looking at the historical Z scores for each passing stock. I don’t recommend you try this at home, it’s a little tedious, but it did allow me to come to some enlightening conclusions.

61.5% of the 39 tickers passed the first criterion (Z score in year 5 > 3) while 20.5% fell in the grey area and the remaining 18% had Z scores below 1.8. Of all 39 stocks, including the 38.5% that did not pass the first criterion, 97% of them had a rising Z score in year 5 from the previous year (year 6). Furthermore, 67% had a higher Z score in year 6 than year 7.

Sometimes Z scores vary significantly from one year to another, so I averaged the Z scores of each of the 39 companies in years 6, 7 and 8 and tested to see if the Z score in year 5 was greater than the average Z score of years 6, 7 and 8. Of the 39 firms, 87% had Z scores in year 5 that were greater than the average scores of the past of three years. Only 13% had Z scores in year 5 that were less than the average Z score of the 3 years prior.

### Discussion of Results

My experiment reinforces the idea that the trend of the Z score is as important—quite possibly more important—than the current Z score itself. Only 61.5% of this high-performing group had a Z score above 3 five years ago. And therefore we should not necessarily write off companies that fall in the grey area of the Altman Z score, or even those below 1.8 because, as shown by the screener, all of them made a comeback and have had a rising Z score for the past 5 years. We would have missed out on some great investments if we adhered to a strict Z score > 3 rule 5 years ago.

Those firms with Z scores below 3 in year 5 (38.5%) managed to turn their fortunes around and go onto do very well. I compared the 5-year price performance of companies that had Z scores above 3 in year 5 against that of firms with Z scores in the grey area and that of businesses with Z scores below or equal to 1.8; the following are my findings. Companies with Z scores below or equal 1.8 are in green, those between 1.8 and 3 are in orange and those with Z scores above 3 are in blue.

Stocks that had Z scores below or equal 1.8 (most likely to go bankrupt) outperformed those with Z scores between 1.8 and 3 (grey area) and those with Z scores above 3 (safe companies) over five years. The performance of firms with Z scores below 1.8 is very impressive but obviously comes with higher risk. For +2,461.9% gains over five years the “Below & Equal To 1.8” group had a collective 1-year beta of 1.13 compared to 0.98 for the “Grey Statistical Area” group (+427.5% gains) and 0.93 for the “Above 3” group (+321.6%).

Am I recommending you put your money in stocks with Z scores below 1.8? No. Even though the +2,461.9% gains over five years are more attractive, +427.5% and +321.6% gains with a greater assurance of safety is not bad. The “Grey Statistical Area” and “Above 3” groups both beat the major benchmarks as shown below:

Ultimately, each investor should gauge how much risk tolerance they have and the amount of work they are willing to put into due diligence. +2,461.9% gains are high risk and require a lot of work to weed out the non-performers and find the few, among those likely to go bankrupt, which will make a turnaround.

Going forward, I will place more weight on what I see as the Altman Z trend with any given company, specifically a rising Z score trend, rather than on the current Altman Z score. Additionally, I will not easily dismiss companies that fall in the grey statistical area but do more research on them because they can make a comeback. Nonetheless, that is not to say that a rising Altman Z score is the perfect predictor for future success because 5 of the 39 stocks (13%, as mentioned earlier) had declining Z score trends over the 3 years prior to year 5 (they reversed this trend in year 5). When the 13% reversed the declining trend in year 5, they went on to outperform the 87% which had rising Z score trends in those 3 years prior to year 5, as shown below:

That is an extraordinary comeback! The 13% gained +2,492.1% compared to +431.7% for the 87% over five years. However, as I mentioned earlier, such gains are associated with greater risk. Consequently, we should be more cautious when considering stocks that have a declining Altman Z score—they don’t all make such great turnarounds. In the ideal world we would all go for the +2,492.1% gain but in reality, we may be better off sticking with the less risky +431.7% gain. Compared to the major benchmarks, the +431.7% gain recorded by the 87% (tickers with rising Z score trends, i.e. the safer stocks) is quite good as shown below:

Above, the 87% are in blue, the NASDAQ is in purple, the S&P 500 is in red and the DJIA is in black. It is apparent that although the 87% do not perform as well as the 13%, they still outperform the DJIA, S&P 500 and the NASDAQ.

Note: Survivorship bias is a huge problem in this analysis, primarily when looking at firms with a Z score below 1.8. Because we are not looking at the entire universe of companies that had Z scores below 1.8 in year 5—we are only seeing the ones that still exist today—we are overlooking the ones that went bankrupt. These 18% survived, and thrived, and that is why they appear in our Increasing Altman Z Score Screener. For context, I ran a screener that gave me a list of firms with Z scores below 1.8 in year 5—it amounted to 848 tickers (criteria was country = US, Exchange = NASDAQ and NYSE, and Z score in Year 5 < 1.8 ). Obviously, the list does not included tickers that may have passed then but were delisted in subsequent years. Although most of the 848 stocks are still around today, not all of them made a comeback strong enough to pass the Increasing Altman Z Score Screener.

### Candidates for Further Research

After spending so much time with these 39 stocks, I wanted to share with you the top performers that you might want to look into further. The following six picks had consistently impressive returns against the S&P 500, sector and industry benchmarks. Only Cal-Maine Foods (which we wrote about this summer ^{[15]} ) has been lagging its sector, industry, and the S&P 500 in the last six months.

Comparing these candidates to peers, it is clear they outperform not only their industries but also their sectors and the S&P 500. The main characteristic they all share is that over the last 5 years, they have consistently beaten their sectors, industries and the S&P 500. For instance, Alaska Airlines (ALK) ^{[17]} (which we also wrote about this summer ^{[18]}( has delivered strong 5-year returns; it has surpassed its peers, outperformed the industry and beaten the S&P 500 as shown below:

The same is also true for Regeneron (REGN) ^{[19]} which when compared to biotech peers that passed our Increasing Altman Z Score Screener shows impressive five year returns.

It is also interesting to note that most of these companies are mid and large cap stocks, except for small cap Natural Health Trends (NHTC) ^{[20]}, when 5 to 6 years ago they were small cap companies. The impressive returns 5-year returns they delivered suggest they are high growth companies. For instance, five years ago Regeneron had $459 million in sales, that has grown to $3,808 million in 2015 (for the nine months ended)—that is 730% growth in sales. Such tremendous growth has taken Regeneron from a being a mid-cap stock of market cap $2.9 billion in 2010 to being a large cap stock of $57.7 billion in 2015. Other companies such as Neurocrine Biosciences (NBIX) ^{[21]} have similar trajectories.

As we learned earlier from Altman, the likelihood of bankruptcy among young companies is very high. But young firms that manage to survive often go on to produce impressive returns. So it makes sense that these companies which started out as small or mid cap often with Z scores below 1.8 yield tremendous growth. If we only looked at companies with Z scores above 3 five years ago, we would have missed these gems, which is why the trend of the Z score is often more important than the current Z score.

### Summing It Up

The Altman Z score is a great metric for measuring the current financial health of a company and determining the odds of that company going bankrupt in the near future. Firms that have Z scores greater than 3, are unlikely to go bust. Those in the statistical grey area (above 1.8 but below 3), can improve their financial health and go on to produce strong returns. However, they require in-depth research to understand their financial condition and future prospects. Those companies with Z scores below 1.8 can also reduce their high probability of bankruptcy and produce impressive results, but they are high risk, usually small cap, and often in industries that require large upfront costs, e.g. biotech. However, as we found out in the case of Incyte in my last article, the trend of the Altman Z score is often more telling than a single Z score. Although a company may have a Z score below 3 and be considered high risk, we need to look at the trend of the Z scores to better understand its risk profile. If a company has a rising Z score over time, we can infer that its financial health has been improving and if otherwise, that it has been deteriorating.

The Increasing Altman Z Score Screener searches for companies with a rising Z score trend and thus helps us find companies that have improving financial health. Its criteria, shown at the beginning of this article, can be modified to incorporate specific your interests. For instance, you can get rid of the criteria “Altman Z-Score [Now]” > 3 to find companies that having an improving financial condition (rising Z score trend) but do not have a current Z score above 3. The Increasing Altman Z Score Screener is now available in the Stock Rover library for free. Happy screening and may the returns be with you!