Shadow Stocks - Investing, with a focus on small stocks

For those who didn't see it, I mentioned selling these puts (too early, as it happens) the other blog recently.

Back in December ZACKS made SGY their "bull of the day" ...

Zacks Bull of the Day Highlights: Stone Energy
Thursday December 17, 2009, 8:26 am EST

Chicago, IL – December 17, 2009 – Zacks Equity Research highlights Stone Energy (NYSE: SGY - News) as the Bull of the Day.

Full analysis of all these stocks is available at http://at.zacks.com/?id=5506
Bull of the Day:

We recommend an Outperform rating for Stone Energy (NYSE: SGY - News) shares following strong third-quarter 2009 results. Stone has moved away from liquidity management in the first half of 2009 to a disciplined organic growth mode.

The Gulf of Mexico (GoM) shelf helped the company deliver a strong quarter, underpinned by both production growth and decreased cost. Last year's acquisition of Bois d'Arc Energy, a pure-play GoM player, has increased Stone's footprint in this region.

Our favorable view of the stock reflects the company's improving balance sheet, positive production growth profile, decreasing cost and improved prospects for capital discipline.

Thanks for the info and welcome to the blog, Paul.

Dave,

Did you do any further digging into SGY other than seeing its Z-score? The reason I ask is that, looking at its financial statements, they seem to actually be improving over the last few quarters, though their quarter ending 12/31/2008 was brutal and is probably screwing up their numbers pretty well (though, in fairness, their March and June quarters weren't exactly stellar either). I just see them maintaining a reasonable level of cash the last 12 months, lowering their current liabilities, as well as their long term debt each quarter. This makes me ask again whether using the Altman scoring when looking back at such a terrible time in the economy is not useful standing alone to determine the future of many companies.

I actually checked the VectorVest sample report on this one too before buying the puts. VectorVest dinged SGY on all three of its measures (relative valuation, safety, and timeliness) and rated it a sell.

Re using the Altman models when the look-back period is a terrible time in the economy, I think I mentioned this last time we discussed this, but the same time period (the trailing twelve months) was also a great period for stocks. SGY, for example, rose 700% from its March 2009 low. Since market value of equity is a numerator in both Altman models, that huge recovery off of its lows has helped SGY's Z"-score. If you want to isolate the impact of that 700% rally on SGY's Z"-score, you could run the Z"-score on SGY manually, using the March low market value of equity along with the current MRQ balance sheet data and TTM income statement data.

To illustrate my point one more way, assuming that SGY is not a manufacturing company (E&P does not qualify, right?) then the three most important variables are the first three, and the inputs that are probably going to get a company a very bad (i.e. negative) score are losses (negative EBIT) and negative retained earnings. If you look at SGY as an example, they had a horrific Q4 08 that completely wiped out much of their retained earnings and more (it made the number significantly in the red) and also saddled their TTM with a huge negative EBIT. Since that quarter, their business seems to be improving, and they turned a profit in the last reported quarter (which isn't the December quarter). So here's a company with a bad Altman score based on the last twelve months, and based almost entirely on the results of one quarter 15 months ago. Again, I have no idea what the fair value is of the stock, I would just be very concerned about taking this Altman score out of context based on previous operating results (which results seem to be offset more and more the closer you get to the present).

That anomalous Q4 08 quarter really makes me doubt the validity or predictiveness of the Altman score for SGY right now.

Watch them announce a secondary offering tomorrow now....

Anyway, you get my point.

E&Ps are not classified as manufacturing companies, so the Z"-score is the appropriate one to use on SGY.

It's certainly possible that the Altman Z"-score won't be predictive in the case of SGY. It's not accurate all the time. But as I mentioned, VectorVest rates SGY a sell. VectorVest's system may not be predictive either, but it shows that different model is similarly bearish about SGY.

I am no opinion whether SGY is a good short or long, but I do think your response regarding the look back period doesn't address the real problem. Sure market value of equity is a numerator in both models, but it's also the numerator for by far the least important input. Saying that an increase in the market value of equity offsets in any material way the other (probably skewed) inputs from the down economy is, in my guess probably flat wrong. Sure it changes the result, but I've read all the papers you put on this site re Altman, and it seems to me that the goal is really to capture the problems that are causing a company to potentially fall into bankruptcy. Those problems are generally operational, not simply Mr. Market being off his meds. EBIT/TA for instance is seven times more heavily weighted (almost) than the market value of equity metric. Looking at EBIT for SGY for example shows an enormous operating loss in the TTM, which may very well not be representative of anything in the near future (but of course could be predictive nonetheless).

I understand your desire to defend the models (and, as a by-product the new site), and I think that every quarter that goes by makes the model *more* useful because the companies will be measured in what may be a more typical environment. At the same time, I don't think that your unwillingness to recognize a potential serious weakness about the models in the short term is justified by what was the economic reality of the past 18 months, and the effects thereof on the inputs to the model.

"value of equity is a numerator in both models, but it's also the numerator for by far the least important input. Saying that an increase in the market value of equity offsets in any material way the other (probably skewed) inputs from the down economy is, in my guess probably flat wrong.

Instead of guessing it's flat wrong, why not run it manually and see what the impact is, if you're interested? It may be that the market value should be more heavily weighted, in general. One material effect of the huge recovery rally is that it made additional capital available to a lot of distressed companies that would have been in trouble without it.

"I've read all the papers you put on this site re Altman, and it seems to me that the goal is really to capture the problems that are causing a company to potentially fall into bankruptcy."

Then you know the models were developed with multiple discriminant analysis -- not a subjective assessment of which factors were more likely to signal bankruptcy. The results appear counter-intuitive to me sometimes. For example -- and this actually came up in a phone conversation with a Short Screen premium member yesterday -- one of the most-distressed companies on the site is there solely because of a hugely negative retained earnings figure. Those negative retained earnings are the result of losses that happened more than one year ago, which is an example of how the models can be impacted by events that happened prior to the TTM.

Also, more generally -- and I may have made this point to you before -- in my observation, Altman scores tend to be less volatile than you might expect in the face of an awful quarter or two. Alloy Steel, for example, stayed in the positive zone even after a couple of awful quarters about a year ago.

"I understand your desire to defend the models (and, as a by-product the new site)"

Just to clarify, the new site (Portfolio Armor) has nothing to do with the Altman models. And the Altman models certainly aren't perfect -- they do have their weaknesses. But I researched other models in the course of developing Short Screen, and I found the Altman models to be the most robust for the purposes of the site. That doesn't mean that I always short or buy puts on a stock just because it has a low Altman score. I usually use the screener as a starting point for my research and then look for some other supporting data.