As the markets become increasingly volatile, there is going to be a temptation to bottom fish. Market sell offs can create an opportunity to buy solid companies at bargain prices that enhance future returns. Buying stocks when they are on sale makes a lot of sense. Benjamin Graham once advised that we should buy stocks like we buy groceries. When things are on sale, we should load up the cart with all our favorites. When things are too costly, more judicious shopping is in order and it makes sense to skip some items until prices are more reasonable. This is sound advice, and more of us should practice the time-honored art of buying low and selling high. However just like we need to check the expiration date of those manager's special super cheap T-Bones, we need to make sure the merchandise we are buying when the market throws a sale is not something that is in the process of going bad.
Use the Available Tools
Fortunately there are simple tools we can use to help make sure the companies we are buying have the type of solid financial conditions and improving prospects that we want to see in companies we own. The Altman Z-score was developed by Edward Altman of the Sterne School of business. The formula uses a few simple measures from financial statements to determine a company’s financial strength. A score over 3 indicates that the company is strong and unlikely to have financial difficulties over the next few years. A score below 1.8 is a sign of possible financial difficulties ahead. (For more, see: How is the Altman Z-Score used in fundamental analysis?)
The Piotroski F-score is a nine-point model that uses financial statements to measure financial condition and prospects. The higher the score the better the company, and its stock price should perform over the next year or two. The model was developed by Professor Joseph Piotroksi, then at the University of Chicago, and has become a valuable tool for identifying companies with sound financial and improving overall fundamental conditions.
Combining these two financial measurements can help us eliminate companies whose stock prices are probably falling for very good reasons. When we are buying into times of high volatility and falling prices, we want to be sure we are buying the best stocks with the best chance to recover strongly when market conditions improve, and avoiding those that may continue lower due to a weak financial position.
Media Stock to Avoid
CBS Corporation (CBS) is an example of a company that investors should avoid bottom fishing under volatile market conditions. Media stocks in general have been under pressure as more and more people cut the cord and turn to alternative forms of viewing. With its shares down 20% so far in 2015, CBS might appear a tempting target. After all, they own not just the flagship network but cable networks including Showtime, television studios, sports channels, and TV and radio stations across the country. However using our two financial measuring tools, we find that CBS is in a weaker financial position and has poorer prospects than we want to see when bottom fishing for quality stocks. CBS earns a Z-score of just .55 and the F-score is just 4, so this is not the type of financially solid company we want to own going forward.
Merger Costs Mean Avoid
Laboratory Corporation of America Holdings (LH) has a pretty good business. They are one of the largest independent clinical laboratory companies in the United States, providing a wide range of clinical tests for doctors, hospitals and long-term care facilities. They also offer substance abuse testing, which is a growing business as companies increase drug testing as a requirement of employment. At first glance it sounds like the perfect candidate for bottom fishing a bad market. However they spent $6.2 billion to expand the company earlier this year, buying Covance Inc. to increase their network and expand internationally. The problem is they borrowed a lot of money to fund the acquisition. Along with long-term debt that had gone from $2.6 billion to $6.6 billion, the F-score dropped to 1.89. The deal has not closed as smoothly as hoped, and the declining financial performance has caused the F-score to drop to just 4. LabCorp is a stock that should be avoided until they improve their financial conditions and post-merger operations run more smoothly.
Weak Oil Takes a Toll
It seems that everyone is trying to bottom fish the oil stocks. This is probably a great idea as David Rubenstein, CEO of Apollo Global Management (APO), one of the most successful private equity firms in the world, recently described oil as the best investment in the world. However, bottom fishing the sector is dangerous in the short term, so purchases need to be limited to the financially strongest companies that have what it takes to navigate a difficult market. Although the company is taking steps to cut its expenses and deal with lower oil costs, Apache Corporation is not a solid choice at this point in time. Apache had been a top-performing oil and gas company from 2000 to 2010, but they made some ill-fated investment in places like Australia, Canada, and Argentina. This has weakened the company, and they could face serious financial issues if oil stays below $50 for an extended period of time. This is all reflected in the Z-score of just .56 and an F-score of 4.
The Bottom Line
Bottom fishing in falling markets can be a solid approach to investing, but you need to be sure and buy those stocks that are financially strong enough to survive until they can thrive in a broad-based market recovery. Using F-scores and Z-scores, we can avoid those that may experience serious financial and operating difficulties.